A range of criteria helps determine which companies are smart buys and have potential for increased future earnings. To find good stocks to invest in, one can analyze the historical ROE (‘return on equity,’) P/E numbers (‘price-to-earnings,’) and in conjunction, the performance of the management team during the indicated time period.
The ROE
This formula is a strong indicator of value for a company. While there are variations, the basic formula is the company’s after tax income divided by the equity of the shareholders. This second number is basically the number of preferred and common shares the company is supported by. While past returns do not guarantee results in the future, a strong annual ROE of 15% or higher for several years demonstrates stability and growth.
Several professional investment firms choose this measurement of stock value to determine the strength of a company within their industry; when the numbers are falling below the 15% mark, it can mean the business is losing ground to its competitors.
Quality is Key
Professionals make their decisions based on more than one method of analysis, however. The ’return on equity’ can show steady growth, but investors are wise to evaluate the percentage of debt listed on the balance sheet. Another form of analysis used to differentiate between false equity and true returns is called the ’ROIC.’ This formula calculates actual returns on the invested capital, and used in conjunction with the ROE, can provide a more detailed picture of how the company is doing financially.
The easier of the two calculations to decipher is ROE however, and as long as the companies being analyzed are not excessively leveraged, is still a good indicator of how skilled the management team is at turning a profit. This number, unadulterated, reflects how well the company turned money from shareholders into earnings.
P/E Factor
The ‘price-to-earnings’ ratio is a way of comparing a stock price to similar sectors in the market. To calculate this number, the investor divides the price per share, say $80 dollars, by how much the company earned per share, say $8. This would yield a p/e ratio of 10. Depending on how similar businesses are doing, this number gives the investor something to compare the relative price by.
This is a useful measure if one has already considered the shareholders return on their invested equity (their shares,) or on the invested capital, and is considering buying this stock. It may be worth calculating the forward P/E as well, which is done by plugging in the projected earnings of professional analysts.
The methods of choosing good stocks to invest in need not be confusing. The investor can follow a simple process by 1) Reading the financial statements of businesses in their area of interest; 2) Finding historical data for a given time period, e.g. 5 years, and calculating the ROE and/or ROIC; 3) Comparing the ‘P/E ratios’ of chosen companies and determining where the greatest value for their money is. With consistent analysis habits, the individual investor can learn to accurately dissect the market.
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