Today’s Trading Lesson From TradingMarkets
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profit from these.
Brice
Return On Equity: How I Use It To
Find Stocks With Fuel To Keep Rising
By Loren Fleckenstein
I’m a trader, not a quant. I
buy off price-and-volume signals, not valuation metrics. But the
intermediate-term momentum trader still targets companies with fundamental
traits most likely to drive cash into, or out of, stocks.
For bullish trades, the prime fundamental trait
is earnings growth. But some level of earnings growth is no great feat. After
all, if a company plows part of its profits back into the business, it starts
the following year with greater resources to raise sales and net income.
True leaders deliver powerful profit growth even
after factoring out this effect. The gauge for this kind of growth is return
on equity, or ROE.
Return on equity is yearly net income divided by
shareholders’ equity straightforward, then multiplied by 100 to convert the
ratio into a percentage. Most ROE calculations add a company’s beginning and
ending equity for a given year and divide that sum by 2 to provide an average
for the year.
As a general rule, the higher the return on
equity, the better. A high or improving ROE indicates management’s ability to
deliver the most bang for the buck. Strong ROE tends to be a good forecaster of
strong future earnings growth. I find ROE most useful to identify leaders within
an industry.
As the following tables show, a steady ROE
requires high earnings growth, whereas modest growth, all other things being
equal, can lead to a falling ROE. Weakening ROEs often portend earnings growth
deceleration to come.
|
Year
|
Base Equity millions $
|
Net Income millions $
|
Net Income Growth %
|
Return on Equity %
|
| 1998 | 35.0 | 10.0 | 29 | 25 |
|
1999
|
45.0 | 12.9 | 29 | 25 |
| 2000 | 57.9 | 16.5 | 29 | 25 |
| 2001 | 74.4 | 21.2 | 29 | 25 |
| 2002 | 95.6 | 27.3 | 29 | 25 |
| 2003 | 122.9 | 35.1 | 29 | 25 |
| 2004 | 158.0 | 45.1 | 29 | 25 |
Source: Timothy P. Vick, Wall
Street on Sale (McGraw-Hill 1999)
|
Year
|
Base Equity millions $
|
Net Income millions $
|
Net Income Growth %
|
Return on Equity %
|
| 1998 | 35.0 | 10.0 | 15 | 25 |
| 1999 | 45.0 | 11.5 | 15 | 23 |
| 2000 | 56.5 | 13.2 | 15 | 21 |
| 2001 | 69.7 | 15.2 | 15 | 20 |
| 2002 | 84.9 | 17.5 | 15 | 19 |
| 2003 | 102.4 | 20.1 | 15 | 18 |
| 2004 | 122.5 | 23.1 | 15 | 17 |
Source: Vick
When assessing a company’s ROE, run a parallel
check on its debt-to-equity ratio. All things being equal, greater debt is
undesirable. However, because rising debt reduces equity, it inflates the ROE
ratio. So as a general rule, discount improving ROEs that coincide with rising
debt.
Watch out for the effects of one-time charges on
ROE. Charges marking down a company’s asset base lower equity in turn, shrinking
the denominator and generating a higher ratio. equity)
Sustaining high ROE in the absence of rising debt
is no small accomplishment. For a case in point, business valuation expert
Timothy Vick cites Callaway Golf (ELY),
which delivered ROEs averaging 43% between 1993 and 1997 while retiring
long-term debt, an extraordinary accomplishment. Those years coincided with a
terrific run in Callaway’s share price.
