While no single ratio or figure in isolation can give a full picture of the health or earnings potential of a company, one measure that deservedly gets investor attention is return on equity (ROE); even famed investor Warren Buffett is a big advocate of calculating and analysing the ROE of potential investment opportunities.
Although many analysts will make all sorts of adjustments to their calculation of ROE, in its most basic form, calculating ROE requires dividing net profit after tax by shareholders equity. Converting the outcome to a percentage gives you an insight into the profit-generating efficiency of a company. A high ROE suggests a company may be generating superior profits from its operations (its equity), while a low ROE may suggest a company is producing a sub-par return from its operations.
In practice, ROE needs to be considered from a number of vantage points. These include the industry the firm operates in – some industries are prone to producing higher ROE than others. It is also important to consider the debt the company carries as this can inflate ROE but also increase the riskiness of the company.
The following four companies stand out after the recent reporting season for having produced not only high ROE in an absolute sense, but also above-average ROE compared to many of their peer group.
- Breville Group (ASX: BRG), which manufactures and markets a range of small appliances.
- Flight Centre (ASX: FLT), a wholesaler and retailer of travel services for both retail and corporate clients.
- SFG Australia (ASX: SFW), a wealth manager that has been increasing its scale through acquisitions.
- Thorn Group (ASX: TGA), a retailer of household goods which incorporates a growing, niche finance business.
All of these companies operate with ROE above 20%. What's more they do it with minimal amounts of debt, indeed most are in a net cash position.
Foolish takeaway
It's hard to outperform in the long run if you regularly over-pay for stocks; so it is always important to understand what a company is worth and compare it to the price you are considering purchasing at. Companies that produce better than average returns and higher than average growth rates are naturally more valuable, these companies are also often of higher quality which again adds to their value. Using ROE as a tool to identify high quality, above average companies coupled with a conservative approach to valuation are 2 attributes which can help lead to investment success.
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More reading
- Flight Centre is now boarding for take-off
- SFG Australia's funds under management grow to $5 billion
Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.
