In a previous article I wrote about how stock pickers can use return on equity (ROE) to find companies that do exceptionally well. It is probably one of the most widely followed performance ratios.
Like always, just one ratio is not enough to get a full picture of a company, so I wanted to add to the tools that investors can use to separate out companies that are more in commodity-like businesses, and home in on the ones that are strong growers with pricing power.
Equity is basically what is left over on the balance sheet after you subtract a company's total liabilities from its total assets. However, equity can still be changed through such things as share buybacks and large dividend payments, releasing funds from total shareholder equity.
Also, companies can purposely alter equity this way to make its ROE look better – reduce the equity denominator and ROE increases with any amount of positive earnings. They know investors look for strong ROE in a company, so this is one way to dress-up the company's performance profile.
A stock picker also wants to see a consistently high level of return on total capital (ROTC). Just like buying a house where you have your cash deposit (your equity) and the loan (debt), we look at a company's shareholder equity and its long-term debt. There is short-term debt, but we only look at the long-term for now.
In the book Buffettology, which describes the way Warren Buffett, chairman of Berkshire Hathaway Inc (NYSE: BRK.A, BRK.B) chooses investments, it defined return on total capital as the net earnings of a business divided by the total capital in it.
There are other ratios that calculate return on capital or return on invested capital, but for easy screening let's keep it simple. We take the NPAT before abnormals and divide it by the sum of long-term debt and total shareholder equity.
Looking at some of the well known and successful businesses, I see that Leighton Holdings Limited (ASX: LEI) has had a ROE over 15% for 2008-2012, but ROTC slipped under 10% in 2011 and 2012 and ideally we want to see over 12% consistently for our screening.
Rio Tinto Limited (ASX: RIO) would regularly have ROE over 20% over the past five years, but in two of those years ROTC went below our 12% threshold, so it doesn't make the cut on consistency.
Interestingly, Woolworths Limited (ASX: WOW), which regularly has net profit margins under 5% annually, had ROE in the high 20s and ROTC in the high teens, so it would make our short list.
Fast-growing companies like REA Group Limited (ASX: REA) had both ROE and ROTC around the mid-30s, which is very attractive since it had no long-term debt from 2010 onwards and was able to keep net profit margins in the high 20s or more.
Foolish takeaway
Finding companies that can sustain high performance ratios like ROE and ROTC narrows down the field of possible investments to those that have a better possibility for higher gains and satisfying long-term returns.
