There are few metrics that investors like more than return on equity, which measures a company's profitability by showing how much net income a company generates with the money which shareholders have invested. I believe when it is used correctly it can be a powerful weapon in helping to choose winning investments.
It is important to understand that a high return on equity does not always mean the company is performing well. As shareholder equity is the result of total assets minus total liabilities, a company that takes on a lot of debt would see its shareholder equity reduce. This makes it far easier for the company to produce a higher return on equity.
The following three companies produce consistent and strong returns on equity, while carrying little debt:
Cochlear Limited (ASX: COH)
Over the last 10 years Cochlear has averaged a return on equity of 37%. It's no coincidence then that during the same period its shares have provided shareholders with a fantastic average return of 11% per annum. The company has a very strong balance sheet and carries very little debt. I believe the company, with its market-leading product offering, will continue to provide shareholders with similar gains for the foreseeable future.
REA Group Limited (ASX: REA)
REA Group, best known for its realestate.com.au website, is another company that has provided incredible returns for its shareholders. The last 10 years has seen shareholders gain an average of 32.8% per annum. While I would not expect this to continue at such a high rate, analysts are expecting earnings to grow by 11.4% per year through to 2018 at least. With the company producing an average return on equity of around 35%, this is a company that has a history of creating value for shareholders.
Nick Scali Limited (ASX: NCK)
Nick Scali has produced a 10-year average return on equity of a whopping 42%. The beauty of its business model is that it holds very little inventory and only orders in the furniture from Europe once the purchase has been made. This gives the company a good level of price control and the ability to react to currency fluctuations. As the company operates at the high-end of the furniture market I feel the necessary price increases, related to higher import costs from Europe due to a weaker Australian dollar, were easily absorbed by consumers. In the last 10 years the company has provided shareholders with an average return of 16.3% per year, and I have every confidence it will continue to do likewise in the future.
Foolish takeaway
I feel these three shares are good examples of using return on equity to choose great investments. Shares with a consistent and strong return on equity, together with low levels of debt have proven to be great performers in the past, and I believe this will remain the same in the future.
