Return on equity is a measure of how well a company can convert the money shareholders have invested into a business (the equity) into profits.
For example imagine you and a friend decide to start a lawn mowing business. You both put in $500 each to get the enterprise started. Because the company is a start-up you keep costs low running the business from home and using your own car — which for the sake of simplicity we'll consider rent-free. With the $1,000 ($500 x 2) you and your friend buy a lawn mower, a trailer, take out an ad in the local paper and have a few dollars left over for 'working capital'.
Luckily, thanks to the advertisement you get a job almost immediately. The cash you receive from your first job allows you to pay the running cost of your business such as the next newspaper ad, petrol and oil. Pleasingly, the cash flow from each job during the year covers all the running costs, which means you don't need to put in any extra equity, and after 12 months in business you sit down to add up what money you have been able to save that wasn't swallowed up in expenses.
It turns out you have 'saved', that is, made a profit, of $200. Assuming you have to pay 30% tax on this, you and your friend are left with $140. In other words the law mowing business in its first year made a net profit after tax (NPAT) of $140. Dividing this NPAT by the equity in the business (the $1,000) gives us the return on equity (ROE). In this case the ROE is 14% — pretty decent.
Berkshire Hathaway CEO Warren Buffett as a rule of thumb looks for businesses earning a ROE of 15% or higher. The beauty of focusing on investing in high ROE businesses is that it can be a good benchmark for quality and for identifying firms with a competitive advantage.
Based on Morningstar's numbers, the following five companies all produced returns on equity of over 20% for shareholders at their most recent full-year results.
1. ARB Corporation (ASX: ARP) manufactures, distributes and sells a range of four-wheel drive accessories such as bull bars and canopies. Its FY 2013 ROE was 23.9%. Impressively, the company has maintained a ROE over 20% for at least the past 10 years.
2. Breville Group (ASX: BRG) is a well-known kitchen and household electrical appliance product firm. In recent years the company has successfully expanded into the US market. ROE was 25% for the year ending 30 June 2013.
3. Flight Centre (ASX: FLT) operates numerous travel agency businesses both in Australia and around the world. The company's ROE is back above 20% with Flight Centre producing a ROE of 23.4% in FY 2013.
4. JB Hi-Fi (ASX: JBH) continues to successfully roll out its consumer electronics retail stores across Australia. The firm produces an incredibly high rate of return on equity. Over the past 10 years ROE has been above 30% each year and for the year ending June 2013, ROE was 47.8%.
5. Prime Media (ASX: PRT) operates both television and radio broadcasting assets across regional Australia including the broadcast of Network Seven into certain regions. Prime's ROE spiked in the past financial year from 20.8% in FY 2012 to 31.6% in FY 2013.
Foolish takeaway
Return on equity alone shouldn't be used by investors to select stocks of course. For one, ROE doesn't adjust for debt, which if significant, could make a company too risky to invest in, despite an appealing ROE profile. Ideally an investment should be judged and tested from many different angles and ROE is one of those angles worth analysing.
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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.
