The return on equity approach
This week we cover a strategy that identifies stocks with a strong return on equity and give you a list of stocks that are currently passing the AAII Return on Equity screen. Return on equity (ROE) can help reveal profitable businesses, but not Wall Street rewards the stock price of these companies? The AAII Return on Equity screen has been rewarded by Wall Street, gaining 11.3% per year since its inception in 1998, while the S&P 500 index has returned 5.5% per year over the same period.
Measure profitability by what shareholders have earned
Return on equity is a popular measure of corporate profitability and management excellence. The measure is determined by dividing the company’s annual profit by shareholders’ equity. This links the profits generated by a company to the investment that shareholders have made and retained within the company. Equity is equal to the total assets of the company minus all its debts and payables. Also known as equity, shareholders’ equity, or even just equity, it represents the investors’ stake in the business. It is also known as the book value of the business.
Warren Buffett considers it a positive sign when a company is able to achieve above-average returns on equity. Buffett believes that successful stock investing is primarily the result of the underlying business; its value to the owner comes primarily from its ability to generate revenue at an increasing rate each year. Buffett examines management’s use of owner’s equity, looking for executives who have a proven ability to use equity in lucrative new ventures or for stock buybacks when they offer superior returns. If profits are properly reinvested in the business, profits should increase over time and the stock price valuation will also increase to reflect the growing value of the business.
Return on equity indicates how much shareholders have earned for their investment in the business. The annual net income of $100 million created on a base of $300 million in equity is very good ($100 ÷ $300 = 0.33, or 33%). However, an annual net income of $100 million versus $3 billion in shareholders’ equity would be considered relatively low ($100 ÷ $3,000 = 0.03, or 3%). Generally, the higher the return on equity, the better. A return on equity above 15% is good, and figures above 20% are considered exceptional. However, it is important to compare return on equity with industry-wide averages to get an accurate idea of how important a company’s ratio is.
Definition of return on equity
Return on equity can be simply expressed as net income divided by common shareholders’ equity. However, return on equity can be broken down into three components: net profit margin, asset turnover and financial leverage. Multiplying these three components together yields a return on equity.
Net profit margin, or net income divided by sales, reflects a company’s efficiency in operations, administration, financing, and tax management per dollar of sales. An increasing or improving profit margin over time translates to increased profits for a given level of sales.
Asset turnover (sales divided by total assets) shows how well a company uses its asset base to generate sales. Poorly deployed or redundant assets lead to low asset turnover which negatively reflects return on equity and profitability.
By multiplying the profit margin and asset turnover, we get a return on assets (ROA). A company can increase its return on assets and, therefore, its return on equity by increasing its profit margin or operating efficiency as measured by the turnover of its assets. Margins are improved by reducing expenses relative to sales. Asset turnover can be improved by selling more assets with a given level of assets. This is the reason why companies try to divest themselves of assets (operations) that do not generate a high degree of sales relative to the value of the assets, or assets that decrease their sales generation. When considering profit margins or asset turnover, it is important to consider industry trends and compare them to a company’s situation within its industry.
Leverage completes the return on equity equation. Leverage – total assets divided by common shareholders’ equity – indicates the extent to which the company has been financed by debt rather than equity sources. The higher the value of this leverage ratio, the higher the financial risk of the company, but also the higher the return on equity. If equity is low relative to debt, the profits generated will result in a high return on equity if the business is profitable. The risk with high debt levels is that a business does not generate enough cash flow to cover interest payments during difficult times.
Debt amplifies the impact of earnings on performance in good and bad years. When there are large differences between return on assets and return on equity, an investor should take a close look at liquidity and financial risk ratios.
The ideal business would maintain a high net profit margin, use assets efficiently, and do all of this with low risk, as evidenced by low financial leverage. The key to working with return on equity is to examine and understand the interaction between the determinants of the ratio.
Implementation of AAII return on equity screen
The main purpose of the AAII Return on Equity screen is to identify companies with consistently high returns on equity. Second, the approach includes features to filter out companies with high debt levels, low margins, and low asset turnover relative to industry medians.
The AAII’s return on equity approach begins by seeking companies operating with a return on equity of 1.5 times their respective industry median over the past 12 months and each of the past five years. This screen reveals the companies whose management has consistently generated the highest profits on its own funds. The AAII Return on Equity strategy does not simply select companies with a return on equity of 20% or more, but rather looks for high ratios relative to industry standards to highlight companies that are outperforming their peers.
Stocks passing ROE screen (ranked by ROE)
As stated above, return on equity is influenced by profitability, efficiency and leverage. Therefore, the next set of screens look for companies that outperform their peers in these areas. First, the AAII’s return on equity approach requires that a company’s net margin (net income divided by sales) exceed the industry median for the past four quarters (last 12 months). The net profit margin examines the profitability of the net income. Companies outperforming their peers translate a higher percentage of sales into profits.
Next, the AAII Return on Equity screen ensures that a company’s asset turnover (sales divided by total assets) has exceeded the industry median for the past four quarters. Asset turnover helps measure the efficiency of a company’s use of its asset base. Companies outperforming their peers generate higher levels of sales dollars for a given level of assets.
The AAII’s return on equity approach also clarifies that, when looking at companies’ financial leverage, the ratio of total liabilities to total assets at the end of the last quarter is below the industry median. A high return on equity can be achieved by having a very high amount of debt and, therefore, very low equity. In such a case, the return on equity would be high, but risky. Financial leverage increases return but also increases risk. Highly leveraged companies have more volatile earnings. Acceptable debt levels vary from industry to industry. More stable industries such as utilities can comfortably carry more debt on their balance sheets than volatile industries such as oil and gas. By comparing liability levels to industry medians, the AAII Return on Equity screen accounts for industry differences.
To help ensure some level of baseline growth, AAII’s return on equity strategy requires positive earnings and sales growth over the past 12 months. The approach also requires that the company’s historical five-year earnings and sales growth rates exceed their respective industry medians. The approach does not specifically look for high absolute growth levels, but simply signs that companies are growing faster than their peers.
The AAII Return on Equity screen also requires that a stock be publicly traded to help ensure liquidity in trades. Therefore, stocks that trade over-the-counter (OTC) are excluded. Due to their special nature, the AAII Return on Equity screen also excludes real estate investment trusts (REITs), closed-end funds and American Depositary Receipts (ADRs).
Actions meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to do due diligence.