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Stock picking tools: Find strong earners with good returns on equity

There are so many ratios in business that it would put sports fanatics to shame. Some cover operational aspects of the business to tell you how efficiently the company is run on the inside. An investor, for the time being, can pass over most of them because they are only interested what comes out in the end as a return on their investment.

Also apart from the percentage return the business is achieving, return ratios speak to the nature of the business itself. Is it a company that can demand a premium for its business, or is it a commodity business that eventually is in a race to the bottom in discounting with high competitive risks?

Return on equity (ROE), the net earnings divided by shareholder equity, is probably the most common ratios followed by investors.

Investors pay money to buy shares, and that’s their equity in the business, so it should be important to them. Investors should be looking for ROE of 12% plus to get a better bang for their equity buck. The past 5-10 year history should show ROE consistently high to really say it’s not a one-off.

Looking at a company like Wesfarmers Ltd (ASX: WES), it had a ROE of 8.69% in FY2013.  Wesfarmers used to have ROE in the high teens and 20s, but in 2007 it took over the Coles Group, and since then ROE has been under 10%.

To give the company credit, every year since the acquisition its ROE has been rising, so in a few more years it may be back in the optimal zone. Its competitor Woolworths Limited (ASX: WOW) has consistently achieved at least mid-to-high 20s, so we know it’s possible to do by running a supermarket business.

Some other stocks with high ROE in 2013 are Ansell Limited (ASX: ANN) (16.75%), Amcor Limited (ASX: AMC) (19.11%), Cochlear Limited  (ASX: COH) (37.14%) and Carsales.com Limited (ASX: CRZ) (54.76%).

Remember, we want to see consistently high ROE.

Foolish takeaway

Just having a high ROE is not a reason for you to buy it though. It is an indicator that perhaps you’re on the right trail of sniffing out a potential stock. Since it only measures the earnings against equity, companies with a lot of debt and smaller equity can seem to have a higher ROE, so by no means is it the sole factor in buying shares.

In my next article, we will add another ratio – return on capital – to the mix and take in debt to see which stocks are standout money spinners.

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Motley Fool contributor Darryl Daté-Shappard does not own shares in any company mentioned. 

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