Return on equity is an important financial gauge commonly used in value investing. So what's it doing in a growth strategy like IBD's
The simple answer: It works as an indicator of financial well-being.
When IBD founder and Chairman William O'Neil studied the characteristics of the most successful stocks, a high return on equity emerged as a key factor.
Thus, return on equity (or ROE for short) is one of a handful of financial metrics adherents of CAN SLIM consider in their stock research.
Return on equity is a measure of financial efficiency, gauging how much profit a company is able to generate from the company's financial net worth (that is, assets minus liabilities).
For any stock you research, look for an annual return on equity of at least 17%. That's the level that tends to set apart the winning stocks from the ordinary, based on the findings of O'Neil's research.
A few examples from history: Intuitive Surgical (ISRG) had 17.1% ROE in the year before its March 2007 . The stock more than tripled until it peaked in December 2007.
Southwestern Energy's (SWN) ROE was 18.4% before its June 2004 breakout that led to a 556% surge over 83 weeks.
Ctrip.com (CTRP) had a 24.3% ROE when it broke out in February 2006 and roared 331% in 115 weeks.
Brazil's Banco Bradesco (BBD)registered a 20% ROE before the October 2004 breakout that led to a 317% rally over 66 weeks.
That doesn't always mean that a company with smaller ROE is a poor investment. Some of the big winners were shy of 17% return on equity when they started their major advances.
But when ROE is strong, it gives investors a sense that it's better poised to continue a solid earnings performance.
To be sure, a high ROE is only part of the fundamentals a solid company should have. Excellent earnings and , superior profit margins and big operating cash flow are other key elements investors must seek.
To figure out return on equity, IBD divides net income for the past fiscal year by average shareholders' equity over the past two years.
Be aware that a high amount of long-term debt can indirectly inflate return on equity because debt reduces shareholder equity.
If you don't want to do the math, a company's return on equity is found in the at Investors.com. It is also shown in the charts that appear in the IBD 50, Your Weekly Review, Stock Spotlight, Big Cap 20 and Sector Leaders.
IBD's combines sales growth, profit margins and return on equity into a letter grade of A to E. Prefer stocks with an A or B.