The return on equity (ROE) is a measure of profitability and corporate management excellence, determined by dividing a firm’s annual earnings by shareholder’s equity. Warren Buffett considers above-average ROE a positive sign, as it reflects the company’s ability to generate earnings and increase stock value over time. A high ROE indicates that shareholders are earning well on their investment in the company, with figures above 20% considered exceptional. The ideal firm maintains a high net profit margin, efficient asset utilization, and low financial leverage to minimize risk.
The AAII Return on Equity screen identifies companies with consistently high ROE compared to industry peers over the last five fiscal years. The strategy filters out firms with high debt levels, low margins, and inefficient asset turnover. By focusing on companies that have consistently outperformed their peers in terms of profitability, efficiency, and leverage, the screen aims to highlight firms with strong potential for future growth and return on equity. The approach does not solely focus on companies with ROE higher than 20% but rather looks for those exceeding industry norms.
To pass the Return on Equity screen, a company must have a net profit margin exceeding the industry median over the last four quarters, indicating strong bottom-line profitability. Additionally, the asset turnover for the firm must exceed industry medians, reflecting efficient use of assets to generate sales. Financial leverage is also considered, with the total liabilities to total assets ratio needing to be below the industry median to avoid excessive risk. Positive earnings and sales growth over the past 12 months, as well as historical growth rates exceeding industry medians, are also required by the strategy.
It is important to note that the stocks meeting the criteria of the Return on Equity screen do not represent specific recommendations for purchase. Investors should conduct their due diligence before making any investment decisions. By becoming an AAII member, investors can gain access to tools and strategies that may provide an edge in navigating market volatility. The strategy outlined in the article offers a systematic approach to identifying companies with strong return on equity potential, helping investors make informed decisions in their stock selection process.
Overall, return on equity is a critical metric for evaluating a company’s profitability and growth potential. By looking beyond just the ROE percentage and considering factors such as profitability, efficiency, and leverage, investors can identify companies with strong fundamentals and promising future prospects. Implementing a structured approach like the AAII Return on Equity screen can help investors filter through the vast universe of stocks and focus on those that have historically delivered strong returns on equity compared to their industry peers.
