Editor’s Note: In these turbulent times, wouldn’t it be great if there was a gauge that told you how effective the management teams are at the companies you’re invested in? A reading that measures a company’s profitability in relation to shareholder equity? There is. It’s called return-on-equity - and in today’s guest column, Investment U’s Education Director Dr. Scott Brown shows you what this key indicator is… how it works… and how you can use it to pick better companies who have strong leaders at the helm.
Martin Denholm, Managing Editor, Smart Profits Report
Measuring Momentum Through The “Return Ratio”
When powerful momentum stocks are charging upwards, it can be difficult to know when to get on board.
But it’s not as difficult as you might think.
If you want the inside track on the best momentum stocks with ultra-explosive gains, just focus on one of the most useful financial ratios around.
It’s called return on equity (ROE).
ROE is one of the best measures of a corporation’s profitability. It shows you how much profit the company generates with the money shareholders have invested. Let me show you how this number works - and how profitable it can be.
Digging For Double-Digit ROE
You calculate ROE by dividing net income by a shareholder’s equity.
The higher the number, the more effective a company is at turning its assets and employees into piles of money for investors.
For instance, between 1998 and 2003, Dell Computer’s highly efficient direct sales and high profit margin strategy paid off in terms of strong earnings growth and a double-digit ROE of 46%. Over that same period, Dell shares soared 91.95%, raining money on shareholders.
The only way that ROE can stay high is by reducing the number of shares outstanding (shareholders equity) or increasing net income. If executives try to hose investors by sucking profit away - issuing more shares through a seasoned equity offering - you’ll catch them by the drop in this ratio.
But other investors who solely focus on net income won’t know the jig is up, because it will stay the same. That’s why ROE is a much better indicator of management effectiveness at bringing home the bacon.
You Don’t Need A Calculator To Figure Out ROE… Just Go To This Page
A stock’s ROE is easy to track through many free financial websites.
I like to use Yahoo! Finance. All you have to do is punch the stock’s ticker symbol into the “Get Quotes” box on the upper left part of the page.
When the company’s information page pops up, click on the “Key Statistics” link. Then scroll down to the “Management Effectiveness” section and you’ll see the value for “Return on Equity (ttm).” This tells you how well management is generating profits for shareholders.
ROE explains the success of Green Mountain Coffee Roasters (Nasdaq: GMCR)…
Brewing Up A Storm
Over the past year, GMCR shares have posted a 125% return (adjusted for the stock’s 3:2 split this past Monday), while the S&P 500 tanked 34.37%.
Behind that outstanding gain is an equally skilful Green Mountain management team, which has squeezed out a 27.85% return on equity, despite the awful market conditions.
It’s made Green Mountain one of the few really safe harbors for the investors to ride out the market’s “storm of the century.”
Just look at how its shares have soared…
Simply put, a higher ROE number tells us how well management is doing, and if a company is undervalued.
So keep a close eye on how ROE changes over time. Ideally, you want it to increase. You can keep track of this by checking your stocks’ “Key Statistics” page on Yahoo! Finance. If the number is in double-digit territory - and increasing - you might want to consider buying the stock.
And if a momentum stock like Green Mountain keeps increasing its ROE, shares should continue to rise, too.
It all starts with education,
Dr. Scott Brown
Editorial Endnote: For more investing education from Scott Brown, check out the new IU Investment Course he just launched. His research has shown that while the stock market is “efficient” most of the time, there are six very lucrative exceptions - which are extremely easy to exploit profitably when you know what they are. And when you do, Scott says, “You’ll never have to worry about money again.”
Disclosure: No positions