With the decision to become a stock investor, possibly also comes anxiety as you may not be sure about how to choose the best companies appropriate for a long-term portfolio. Financial ratios may play an important part in evaluating the performance and financial condition of a business.
Today I’d like to discuss two metrics that may help interested readers make better-informed decisions when trying to sort the winner shares from the losers.
Return on equity
Is management able to turn assets into profits?
Return on equity (ROE) is a profitability ratio that is used to assess how efficient and productive a company is with its money.
The formula is derived by dividing a company’s net income by its share capital base. In other words, it measures how much a company is earning relative to the money it has kept within the business.
It is expressed as a percentage, such as 18%. A higher ROE indicates that management is more effective at converting capital into profit. My own rule of thumb is to look for ROEs above 15% as I screen for investments.
Investors may also use ROE to compare competitors in a given industry. So, all else being equal, a high ROE is better than a low one.
For most companies, debt is an important reality of running a business as they may need to borrow for a variety of reasons. Building or growing a business requires investment capital.
Therefore, looking at the ROE alone may not always always suffice, as high debt levels may boost a company’s ROE and give the illusion that the business is generating high returns.
In other words, management can significantly increase ROE by taking on debt. However, debt may also mean increased level of risk for the company. With increased risk, investors would like to see increased returns.
If the cost of debt financing outweighs the increased returns generated, then investors may be alarmed and sell a company’s shares.
Investors therefore also need to look at the debt-to-equity ratio in order to ascertain if debt levels might be too high with respect to the share capital of the company. This metric is a leverage or gearing ratio that shows whether a company’s capital structure is tilted toward debt or equity financing.
A high debt-to-equity ratio generally means that a company has aggressively financed its growth with debt.
This metric varies across industries. For example, a capital-intensive industry like manufacturing often has a higher ratio that can be greater than 2.
If a business has a debt-to-equity ratio of 0.75, it means that its liabilities are 75% of shareholders’ equity, or that creditors provide 75p for each pound provided by shareholders to finance the assets.
If the debt-to-equity ratio is quite low, for example close to zero, then investors may become sceptical. After all, management may not be realising the potential returns it could attain from further borrowing to grow operations.
Unilever has a debt-to-equity ratio of 2.2. Thus it’s worth noting the significant use of debt by Unilever. Its high ROE has clearly benefited from the group’s use of debt.
Reckitt Benckiser’s debt-to-equity is about 1, which highlights that creditors and shareholders equally contribute to its assets.
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tezcang has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended Unilever. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.