Finding the best shares to buy now comes down to two things. The first is a great business. The second is a great price. I have a formula that helps me find both.
In order to find great stocks I look at two numbers. The first measures how effectively a company uses its equity in generating income. The second measures how expensive the company is in terms of its equity.
The two numbers I look at are a company’s return on equity (ROE) and price-to-book (P/B). The ROE indicates quality, and the P/B ratio helps evaluate price. Most importantly, the relationship between the two helps me identify great investing opportunities for my portfolio.
Return on equity
The ROE ratio is the company’s net income as a percentage of its book value. So if a company has a book value of £1,000,000 and net earnings of £150,000 last year, it would have a ROE of 15%.
In general, a higher ROE number indicates a higher quality business. When a company has a high ROE, this means that it generates a lot money without needing to maintain substantial assets to do so.
A ROE of over 15% is generally interesting to me. A number over 30% is very impressive. Good examples of high quality businesses with strong ROE numbers are Croda International (19.21%), Halma (21.81%), and Spirax-Sarco Engineering (25.18%).
Price-to-book
The second part of the formula is the P/B ratio. This compares the price of the business to the value of its equity to give an idea of whether or not the company is expensively priced. If a company has a market cap of £1,500,000,000 and £750,000,000 in equity, it has a P/B ratio of two.
Generally speaking, a lower P/B ratio is better. But more important is the relationship between the ROE and the P/B. In my view, a company with a strong ROE justifies a higher P/B multiple. In general, I think that when the ROE is equal to or greater than 10 times the P/B multiple, this represents an attractive investment opportunity.
In the case of Croda, Halma, and Spirax-Sarco, all three trade at fairly high multiples. Croda has a P/B of 5.88, Halma shares trade at a P/B of 7.44, and Spirax-Sarco has a P/B of 9.15.
Summary
Great businesses are able to make strong returns on equity. But it’s also important to be aware of how many times equity a company’s share price represents. I think that looking for companies that have a high ROE and comparing this to the P/B gives a good initial idea of how attractive an investment opportunity is.
By themselves, these numbers only give a starting point into researchinga company. It’s also important to look at whether a company’s metrics are being skewed by unusual financial results. And it’s also important to assess the company’s capacity for earnings growth. But these two numbers help me to get a good start in finding the best shares to buy now.
