An important metric for investors to understand and utilise when analysing stocks is the concept of return on equity (ROE). Essentially, ROE measures the return (measured by profit) that a company is generating by utilising the money that shareholders have invested.
Intuitively it makes sense to compare the return being generated by a company on the money invested in that company, and in fact Warren Buffett is an enthusiastic proponent of the metric.
Most importantly, ROE can help identify companies that are not only creating value for shareholders but also identify companies that could possess a sustainable competitive advantage.
Here are four stocks which all possess high returns on equity. The parameters for the search criteria used to identify these four stocks included: a market capitalisation of less than $1 billion, forecast earnings per share (EPS) growth in the "double digits" (in other words over 10%), a strong balance sheet – indeed in most cases these companies are actually net cash, and importantly a ROE of at least 20%.
1) RCG Corporation Limited (ASX: RCG) is a specialty retailer of athletic footwear primarily through The Athlete's Foot branded store network. Interestingly, despite a competitive retail environment, RCG has managed to maintain above average returns which suggests it possesses some form of comparative advantage. It should produce ROE of around 24% in financial year (FY) 2014.
2) Ozforex Group Ltd (ASX: OFX) has carved out a profitable niche as the "go-to" online provider for customers needing a foreign exchange transaction. While the high level of profitability is bound to encourage competition, currently OzForex enjoys ROE of over 50%.
3) Sirtex Medical Limited (ASX: SRX) looks set to continue its high levels of growth thanks to its innovative treatment for liver cancer. The technical nature of Sirtex's product gives the company a strong comparative advantage which is displayed by its expected ROE of 24% in FY 2014.
4) SFG Australia Ltd (ASX: SFW) is a full service provider of wealth management services. A 2011 merger has given SFG a substantial national footprint and a ROE of around 20%.
Foolish takeaway
It's always handy to compare a firm's ROE against its peer group as this allows an investor to understand what the average return for firms operating in a particular industry are. In other words – certain industries have the ability to generate higher average returns on equity than others.
Another important aspect of ROE analysis is to identify companies that also have the ability to reinvest their earnings – Sirtex and OzForex stand out in this respect. This is important as it allows for earnings to be compounded at these high rates of ROE which is generally more valuable to a shareholder than a high ROE company that does not have reinvestment opportunities and instead pays those earnings out as a dividend.
