Use ROE to find stocks that generate profit for every dollar invested
What is the winning combination that measures the strength of a business?
The answer is: High return on equity and low leverage.
Let’s start with return on equity, a key measure of the health of a stock. It shows how much profit a business generates for every dollar invested. To calculate return on equity, take a company’s annual net income and divide it by total shareholders’ equity. Multiply this number by 100 to get the percentage of ROE.
Fortunately, you don’t have to do this calculation yourself. MarketBeat provides this ratio on its company profile pages. For example, here is an overview of the profile of Apple (NASDAQ: AAPL). Scroll down to “Profitability” data on the right side. There you will see the percentage of ROE.
ROE is a good measure of how effectively business leaders put capital to work. It also shows you how the profitability of a business is relative to its growth. As a company’s equity increases, it becomes more difficult to maintain a high ROE percentage.
Of course, earnings per share is another good and very commonly used indicator of profitability relative to ownership. ROE is just another way of looking at profitability when it comes to equity and provides a deeper insight into a company’s strength.
Researchers have found that an ROE of 17% or more is a good place to start adding stocks to a watchlist. This is not the only criterion – increasing sales and revenue are also key elements in the selection – but it is one criterion you might consider adding to the mix.
There are a few caveats.
First, there is a link between ROE and a company’s profit margin. Sometimes you’ll see a company with strong annual pre-tax profit margins, but their ROE is below 17%, or lower than their industry competitors. In these cases, you could make an exception to the 17% rule. These cases are quite rare, however, and you want to make sure that the pre-tax margin is above the industry average.
There is also a relationship between profit margins and return on equity. In some cases, you can allow a lower ROE than your peers, if the company has top-notch annual pre-tax margins. In general, a pre-tax annual margin of 17% or more is a sign of fundamental strength. You also want to see if a company’s pre-tax margin is among the best in its industry.
The second caveat concerns debt.
Many companies borrow money to finance new projects. As these products and services become profitable, ROE increases. However, you will often see these companies showing both high ROE and fairly high levels of debt.
When you identify companies with high ROE, check their industry peers. What kind of ROE and debt levels do competitors have? If your business has an above-average ROE relative to its industry and has slightly above-average debt, these factors may be related.
Sector comparison is necessary because some industries are more capital intensive than others. For example, airlines need a lot more capital to operate than software companies. A comparison of debt levels between companies in these disparate industries would be essentially meaningless.
But in general, a high debt ratio is riskier for lenders and investors because it increases the chances that a business will not be able to repay its debt if it is going through a difficult time.
On the other hand, it can trigger red flags if a business fails to leverage leverage to finance its growth. Institutional investors can find companies that may not be reaching their full potential because they avoid borrowing to finance potentially profitable projects.
As you perfect your stock selection chops, you’ll quickly learn that there isn’t a single gauge that will deliver that perfect ‘aha’ moment for discovering the next big thing.
But ROE is a solid metric to include in your research, as it can shed light on a company’s capital use compared to others in its industry. This can show you whether the action you are considering has an advantage over your competition and has a better likelihood of delivering the return you are looking for.
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7 Reddit actions that have a chance to be special
As a conservative investor, I have a reluctant admiration for the small army of retail traders who make their dreams come true. I’m talking, of course, about the group of day traders who have gotten into the habit of finding low-cost stocks (especially those with high short-term interest) and trying to send them “to the moon.”
They are called meme stocks, casino stocks, or Reddit stocks (named after the website where some of these traders congregate). It all means the same thing. And while I say I admire the traders who profited from these stocks, I do so from a safe distance.
Many of these stocks were penny stocks. And they were penny stocks for a reason. No amount of speculative rocket fuel will change that. But if you look at some of these stocks as objectively as possible, there may be some hope.
And in this special presentation, we’re going to take a look at seven Reddit actions that might have a chance to have a life beyond this current mania phase.
Check out the “7 Reddit Actions That Have a Chance to be Special”.
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