This has been an earnings season to remember. At time of writing this, 405 companies in the S&P 500 have reported quarterly results. On average, these blue chips posted 10.5% annual earnings growth and 1% earnings growth. 68% of these companies topped analyst earnings estimates, with an average 3.8% earnings surprise.
Not too shabby. But this is not the real reason why I’m writing to you today. As important as the top- and bottom-lines of an income statement are, they’re only part of the picture. Now that we’ve had a chance to digest the latest and biggest earnings news, I want to dig a little deeper into a powerful metric that doesn’t always get the credit its due: Return on equity.
We hear this term thrown around by the financial media all of the time, but what is it? Return on equity (ROE) is the amount of profits a company generates with the money shareholders have invested in it. In simple terms, ROE is a gold standard of how well-managed a company is. If a company is run well, its net income will dramatically outpace what investors have pumped into it. If a company is lazy or poorly run, the value of shares investors own will be more than the profits the company actually produces. I can’t interview every senior manager at a company, so I like to think of ROE as a report card for management.
To check out a company’s return on equity, simply take a business’s net income and divide that by the amount of money shareholders own in common stock. You can also visit a financial news site—like this key statistics page for Apple Inc. (AAPL) on Yahoo Finance. You’ll see there that Apple has a ROE of 28.82%. This means that for every dollar that investors pump into AAPL stock, Apple turns nearly $0.29 of that into profit. To get a sense of how Apple compares with the competition, you can then check out the industry average for ROE. In the Electronic Equipment industry, it’s 23.6%, so Apple is doing well.
And if you don’t have quite the time to analyze each and every one of your holdings, that’s precisely what Portfolio Grader is for. If you run AAPL through Portfolio Grader, it will tell you pretty much the same thing that the earlier analysis did: It receives an A for return on equity. Of course, the gadget giant is struggling on other fronts, so I wouldn’t recommend it for new money right now.
No, when it comes to return on equity I have my sights on other opportunities, three to be exact. Two are major players in China’s education market and one is a designer of branded women’s apparel and accessories. In fact, one of these stocks just surged over 20% after posting 44% sales growth and 130% earnings growth for the fourth quarter. Click here to see my top-rated stocks by return on equity in Portfolio Grader.