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Analyze Stocks With Two Simple Ratios

Analyze Stocks With Two Simple Ratios

Contents

INTROStocks & MarriageAnalyze Stocks With Two Simple RatiosConclusion
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INTRO

Life is hard. Every day you’re forced to make 100+ decisions, with each impacting your energy levels. And by the end of the day, you’re probably too tired to think.

You’re in no condition to be looking at 50+ financial ratios, and you definitely don’t want to waste your energy on the wrong companies.

So, let me tell you how to find the right companies by focusing on two simple ratios. Just enough to realize whether a company is worth digging into.

But first, a lovely analogy.

Stocks & Marriage

Finding the right partner is probably the most difficult decision you’ll ever have to make.

If you don’t trust me, trust Charlie.

     “If you want to ruin your life, spend it trying to change your spouse.” – C. Munger

I’m assuming most of you seek (or have sought) partners in a traditional way. You spot someone attractive, talk to them, go out for a while, and learn about each other. Then, finally, you commit to a relationship. This process is somewhat relatable to investing.

You spot an attractive company, read about it, do some research, and learn about the business. Then, finally, you commit to a buy & hold relationship.

Since I’m no love guru, I’ll focus on the investing side. And because we all live busy lives, let me show you a way to quickly spot whether a stock is worth committing to.

Enter two simple ratios.

Analyze Stocks With Two Simple Ratios

Financial advisors will 100% try to make investing complicated. After all, it’s their bread and butter. But in reality, all you need is one question:

        

          If I invest $1 how much am I getting back every year?

And that’s exactly the question that ROE and ROIC answer. Let me tell you a bit more about them.

Return On Equity (ROE)

ROE (Return on Equity) is like checking how well a company is using your money. It shows the profit a company makes compared to the money you and other shareholders put into it.

The formula is:

ROE = (Net Income / Shareholder Equity) X 100%

A healthy ROE might be around 15% or higher. For example, if you invest $1 in a company and it makes $0.15 in profit for you, that's a 15% return. The average return on equity for a U.S. company over the past 60 years has been about 12%.  And, of course, as investors we're always aiming for above-average, so an ROE above 12% for a company is worthy analyzing further for possible investment.

High rates of ROE can reflect the presence of a competitive advantage with a company, especially if that high rate of ROE is consistent!  If it's consistent, then the competitive advantage is likely strong and durable.

But never just look at ROE in isolation. You always want to couple the ROE analysis with an analysis of ROIC, as well.

Return On Invested Capital (ROIC)

ROIC (Return on Invested Capital) looks at how efficiently a company uses all its money to make profits, including both yours and borrowed money (both equity and long-term debt).

The formula is:

ROIC= (NOPAT / Invested Capital) X 100%

Before you get scared, NOPAT is simply like everything a business earns after taxes and paying back the banks.

A good ROIC could be above 10%. A 10% ROIC is our minimum threshold when evaluating stocks, and anything above that level is even better.

Imagine you lend $1 to a company, and it gives you back $0.10 in profit; that's a 10% return on your investment.

If you're not particularly good with math and putting together ratios and calculations such as ROIC and ROE, don't worry. Most investment analysis tools will have these figures readily available for you to observe for all of the companies covered by their platforms. But you just need to know how to interpret and use the metrics accordingly.

For example, using the powerful Tykr stock screener tool, I can readily observe the assessment of both ROIC and ROE for Microsoft (MSFT), for example.

Source: Tykr (Microsoft Underlying Metrics)

Below is a screenshot of key financial ratios from the Tykr platform. The screenshot shows a few such ratios for Microsoft (MSFT), with a comparison versus industry average, sector average, and market average. Info on additional metrics beyond what is shown are also available.

Source: Tykr (Microsoft Ratios)

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The Big Difference

ROE, or Return on Equity, is like asking your buddy how well they're doing with the money they invested in a business. It's all about how much profit they're making compared to the amount of money they put into the company.

ROIC, or Return on Invested Capital, is like chatting with another friend about how efficiently a company is using all the money it has, including both what it borrowed and what shareholders invested. It gives you a sense of how good the company is at making money from all its resources, including long-term debt.

That being said, you definitely should use both when screening for your next investment. Learn more about key profitability ratios in our prior article Evaluating Stocks Using Profitability Ratios.

Here is an image for all you visual learners.

Consistency is everything. Don't look for occasionally high returns on equity, but ones that consistently earn high returns. Additionally, look for that consistency with both returns on equity and returns on invested capital. Analyze stocks with both of these two simple ratios - ROE and ROIC.

Before you go, I have to warn you about one more thing.

Be Careful Or You’ll Be Manipulated

This is an intermediate topic but I still want to mention it in case you’ll ever want to dig deeper.

Some CEOs will manipulate the numbers on purpose. One trick is taking on more debt. It might make profits seem bigger because shareholders' equity shrinks in comparison.

So, always look to identify companies with high rates of ROE, but be sure to conduct a similar analysis with ROIC as well. ROIC takes into account not only management's use of equity but also how efficiently its using corporate debt.  Evaluation of this ratio also helps to ensure ROE isn't high only as a result of using too much debt.

Another trick some companies use to inflate ROE? Share repurchases. By reducing the number of shares, it makes earnings (a key part of the ROE calculation) look better, even if overall profits haven't changed much. It's like trying to make your grades seem better by changing the class size! The issue with looking at high rates of ROE in isolation is that some companies deliberately shrink their equity base with large dividend payments or share repurchase programs.

While share repurchases can also be an attractive, value adding corporate strategy, they skew the ROE metric. So, look at the ROIC also to help screen out inflated levels of ROE and put things into proper perspective. As reiterated by Jensen Investment Management's write-up here, both ROE and ROIC should be used as effective indicators to assess a company's financial capabilities.

Share repurchases are another story. Learn more about them in a prior article found here. To get my best work, feel free to join the world’s most powerful stock market newsletter for wealth, stability, and happiness.

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Information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions.  I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP. The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.

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