Amcor PLC (ASX: AMC), CSL Limited (ASX: CSL) and Magellan Financial Group Ltd (ASX: MFG) have all demonstrated their ability over the past 5 years to consistently produce high returns on equity (ROE). As an investor, this is a highly desirable attribute and as such I would expect that these three companies are often being considered for investment.
How have these three companies performed recently?
From 2014 to 2018, Amcor had the highest rate of ROE of these three companies, averaging in excess of 65%. During this same period Magellan and CSL both averaged in excess of 40%. Along with these high returns on equity, the companies have also produced high annual rates of return to shareholders. Over the past 5 years, Amcor has produced an annual rate of return to shareholders of 14%, while Magellan and CSL produced 41% and 28%, respectively.
What’s so good about high return on equity?
ROE measures the amount of profit generated relative to the amount of capital invested by shareholders. The preference is for less capital to be required in generating large profits. As a company grows, continuing to produce high ROE becomes more and more challenging, as there is more capital which needs to be invested. Therefore, companies that can do this over the long term likely have superior management or a very strong business model.
ROE is often sighted as an excellent indicator of a company’s overall economic performance. Searching for companies with high ROE can be a worthwhile method for refining a list of possible share investments. However, I don’t believe this metric is enough to single-handedly justify an investment. Share price, company cashflow, the level of debt and the presence of a sustainable long-term competitive advantage are examples of some other worthwhile considerations.
Companies that produce high ROE have the ability to generate significant returns to shareholders. Although I believe this metric is a good measure of a business’s overall performance, it should not be used as the sole criteria for judging an investment opportunity. In particular, close attention should also be paid to the price of the share, ensuring that this price is justifiable. This will ensure greater returns on an investment over the long term.
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Mitchell Perry has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of CSL Ltd. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.