The Return on Equity Approach

This week, we cover a strategy that identifies stocks with strong return on equity and give you a list of stocks that currently pass the AAII Return on Equity screen. Return on equity (ROE) may help to reveal profitable firms, but does Wall Street reward the stock prices of these firms? The AAII Return on Equity screen has been rewarded by Wall Street, gaining 11.3% annually since inception in 1998 while the S&P 500 index has returned 5.5% annually over the same period.

Measuring Profitability by What Shareholders Earned

Return on equity is a popular measure of profitability and corporate management excellence. The measure is determined by dividing the annual earnings of the firm by stockholder’s equity. This relates earnings generated by a company to the investment that stockholders have made and retained within the firm. Stockholder’s equity is equal to total assets of the firm less all its debt and liabilities. Also known as stockowner’s equity, owner’s equity or even simply equity, it represents investors’ ownership interest in the company. It is also known as the book value of the company.

Warren Buffett considers it a positive sign when a company is able to earn above-average returns on equity. Buffett believes that a successful stock investment is the result first and foremost of the underlying business; its value to the owner comes primarily from its ability to generate earnings at an increasing rate each year. Buffett examines management’s use of owner’s equity, looking for management that has proven its ability to employ equity in new moneymaking ventures, or for stock buybacks when they offer a greater return. If the earnings are properly reinvested in the company, earnings should rise over time and stock price valuation will also rise to reflect the increasing value of the business.

Return on equity indicates how much the stockholders earned for their investment in the company. Annual net income of $100 million created on a base of $300 million in stockholder’s equity is very good ($100 ÷ $300 = 0.33, or 33%). However, $100 million in annual net income relative to $3 billion in shareholder’s equity would be considered relatively poor ($100 ÷ $3,000 = 0.03, or 3%). Generally, the higher the return on equity, the better. A return on equity above 15% is good, and figures above 20% are considered exceptional. However, it is important to compare return on equity with industrywide averages to get a true feel for the significance of a company’s ratio.

Return on Equity Defined

Return on equity can be simply stated as net income divided by common stockholder’s equity. However, return on equity can be broken down into three components: net profit margin, asset turnover and financial leverage. Multiplying these three components together results in return on equity.

The net profit margin — net income divided by sales — reflects how efficient a firm is in operations, administration, financing and tax management per sales dollar. A rising or improving profit margin over time translates into an increase in earnings for a given level of sales.

Asset turnover — sales divided by total assets — shows how well a company utilizes its asset base to produce sales. Poorly deployed or redundant assets result in a low asset turnover that adversely reflects return on equity and profitability.

Multiplying profit margin and asset turnover together results in return on assets (ROA). A firm can increase its return on assets and thereby its return on equity by increasing its profit margin or its operating efficiency as measured by its asset turnover. Margins are improved by lowering expenses relative to sales. Asset turnover can be improved by selling more goods with a given level of assets. This is the reason why companies try to divest assets (operations) that do not generate a high degree of sales relative to the value of the assets, or assets that are decreasing their sales generation. When examining profit margins or asset turnover, it is important to consider industry trends and compare them to how a company is doing within its industry.

Financial leverage completes the return on equity equation. Financial leverage — total assets divided by common stockholder’s equity — indicates the degree to which the firm has been financed through debt as opposed to equity sources. The greater the value of this leverage ratio, the greater the financial risk of the firm — but also the greater the return on equity. If equity is small relative to debt, then earnings generated will result in a high return on equity if the firm is profitable. The risk with high levels of debt is that a company will not generate enough cash flow to cover the interest payments during challenging times.

Debt magnifies the impact of earnings on return during both good and bad years. When large differences between return on assets and return on equity exist, an investor should closely examine the liquidity and financial risk ratios.

The ideal firm would maintain a high net profit margin, utilize assets efficiently and do it all with low risk, as reflected by a low financial leverage. The key in working with return on equity is examining and understanding the interplay between the determinates of the ratio.

Implementing the AAII Return on Equity Screen

The primary goal of the AAII Return on Equity screen is to identify companies with consistently high returns on equity. Secondarily, the approach includes characteristics to filter out firms with high levels of debt, low margins and low asset turnover relative to industry medians.

The AAII Return on Equity approach starts by seeking out companies operating with a return on equity 1.5 times their respective industry median over the last 12 months and each of the last five fiscal years. This screen helps to reveal companies whose management has consistently generated the highest profits from its equity capital. The AAII Return on Equity strategy does not simply screen for companies with return on equity levels of 20% or higher, but instead looks for ratios that are high relative to industry norms to highlight firms outperforming their peers.

Stocks Passing the Return on Equity Screen (Ranked by Return on Equity)

As discussed above, return on equity is influenced by profitability, efficiency and leverage. Therefore, the next set of screens seek companies outperforming their peers in these areas. First, the AAII Return on Equity approach requires that a firm’s net margin (net income divided by sales) exceed the industry median over the last four quarters (trailing 12 months). Net profit margin looks at bottom-line profitability. Firms exceeding their peers are translating a higher percentage of sales into profits.

Next, the AAII Return on Equity screen makes sure that the asset turnover (sales divided by total assets) for a firm exceeds the industry median over the last four quarters. Asset turnover helps to measure the efficiency of a firm’s use of its asset base. Firms exceeding their peers are generating higher levels of sales dollars for a given level of assets.

The AAII Return on Equity approach also specifies that when looking at the financial leverage of firms, the ratio of total liabilities to total assets at the end of the most recent quarter is below the industry median. A high return on equity can be attained by having a very high amount of debt and, therefore, a very low stockholder’s equity. In such a case, return on equity would be high, but risky. Financial leverage increases return but also increases risk. Highly leveraged firms have more volatile earnings. Acceptable levels of debt vary from industry to industry. More stable industries such as utilities can comfortably carry more debt on their balance sheets than volatile industries such as oil and gas. By comparing levels of liabilities to industry medians, the AAII Return on Equity screen takes industry differences into account.

To help ensure some basic level of growth, the AAII Return on Equity strategy requires positive earnings and sales growth over the past 12 months. The approach also requires that the firm’s five-year historical growth rates in earnings and sales exceed their respective industry medians. The approach does not specifically look for high absolute levels of growth, just signs that the firms are expanding faster than their peers.

The AAII Return on Equity screen also requires that a stock be listed on an exchange to help ensure trading liquidity. Therefore, stocks that trade over the counter (OTC) are excluded. Due to their special nature, the AAII Return on Equity screen also excludes real estate investment trusts (REITs), closed-end funds and American depositary receipts (ADRs).

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The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.

If you want an edge throughout this market volatility, become an AAII member.

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Since inception in 1978, the nonprofit AAII has helped over 2 million individuals build their investment wealth through programs of education and publications.

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American Association of Individual Investors

Since inception in 1978, the nonprofit AAII has helped over 2 million individuals build their investment wealth through programs of education and publications.