Analysts and market commentators, including us here at The Motley Fool Australia, have frequently warned about focusing on dividend yields alone.
That's where it can pay to consider companies with high returns on equity (ROE). ROE is important for a number of factors. It generally shows that management are making good decisions and generating a high return on the capital they have employed.
If I had $1 million dollars but only managed to generate $5,000 a year in profit, that would be a pretty poor return. But if I could generate $200,000 a year on that same capital, then I'd obviously be doing a much better job.
It's the same for company management.
But not all companies are the same. Some are more capital intensive, like steel manufacturers or airlines, while others, such as fund management companies, need very little equity to generate decent returns.
Here are 5 companies with ROE of more than 20% and dividend yields of more than 5%.
| Company Name | Current price | Market cap | Dividend yield | Return on equity |
| Tamawood Limited (ASX: TWD) | $3.52 | $90m | 7.1% | 76% |
| Dick Smith Holdings Ltd (ASX: DSH) | $1.33 | $315m | 9.0% | 23% |
| Flexigroup Limited (ASX: FXL) | $2.39 | $727m | 7.4% | 21% |
| Platinum Asset Management Limited (ASX: PTM) | $6.87 | $4,030m | 5.4% | 59% |
| ERM Power Ltd (ASX: EPW) | $2.23 | $539m | 5.4% | 22% |
Source: CapitalIQ
As you can see from the table, home builder Tamawood and fund manager Platinum Asset Management are generating astonishing returns on equity. What is even more impressive is that both have net cash positions. Return on equity can be boosted through the use of debt, so it's important to also check a company's debt levels.
Qantas Airways Limited (ASX: QAN) generated a reasonable 17.7% ROE last financial year, but thanks to its billions of debt, return on invested capital (ROIC), which includes debt plus equity, was just over 9%.
Tamawood had no debt and $3.4 million in cash at the end of June 2015, while Platinum had $128 million in cash and a further $200 million in term deposits. Given the low-interest rates available, Platinum is doing a sterling job generating such high returns on shareholders equity. Consumer electronics retailer Dick Smith, financial services company Flexigroup and utility ERM Power aren't slouches either, but appear to be flying under the radar.
Foolish takeaway
Warren Buffett has often said that he likes to invest in companies with high returns on equity. The above five offer the best of both worlds, paying out substantial dividends as well.
