Return On Equity: How I Use It To Find Stocks With Fuel To Keep Rising

I'm a trader, not a quant. I buy off price-and-volume signals, not valuation metrics. But the intermediate-term momentum trader still targets companies with fundamental traits most likely to drive cash into, or out of, stocks.

For bullish trades, the prime fundamental trait is earnings growth. But some level of earnings growth is no great feat. After all, if a company plows part of its profits back into the business, it starts the following year with greater resources to raise sales and net income.

True leaders deliver powerful profit growth even after factoring out this effect. The gauge for this kind of growth is return on equity, or ROE.

Return on equity is yearly net income divided by shareholders' equity straightforward, then multiplied by 100 to convert the ratio into a percentage. Most ROE calculations add a company's beginning and ending equity for a given year and divide that sum by 2 to provide an average for the year.

As a general rule, the higher the return on equity, the better. A high or improving ROE indicates management's ability to deliver the most bang for the buck. Strong ROE tends to be a good forecaster of strong future earnings growth. I find ROE most useful to identify leaders within an industry.

As the following tables show, a steady ROE requires high earnings growth, whereas modest growth, all other things being equal, can lead to a falling ROE. Weakening ROEs often portend earnings growth deceleration to come.

Source: Timothy P. Vick, Wall Street on Sale (McGraw-Hill 1999)

Source: Vick

When assessing a company's ROE, run a parallel check on its debt-to-equity ratio. All things being equal, greater debt is undesirable. However, because rising debt reduces equity, it inflates the ROE ratio. So as a general rule, discount improving ROEs that coincide with rising debt.

Watch out for the effects of one-time charges on ROE. Charges marking down a company's asset base lower equity in turn, shrinking the denominator and generating a higher ratio. equity)

Sustaining high ROE in the absence of rising debt is no small accomplishment. For a case in point, business valuation expert Timothy Vick cites Callaway Golf (ELY | Quote | Chart | News | PowerRating), which delivered ROEs averaging 43% between 1993 and 1997 while retiring long-term debt, an extraordinary accomplishment. Those years coincided with a terrific run in Callaway's share price.