U.S. Markets closed

Use Return On Equity, Margins To Confirm Great Profit Growth

A company's earnings provide the principal picture of its financial performance, but not a comprehensive one.

Investors also need to check the company's profit margins and return on equity to judge the quality of the earnings. Strong readings in both measurements are hallmarks of winning stocks before they make big price runs.

There are cases, though, when a solid annual pretax margin can offset a middling return on equity, and when a strong ROE compensates for a mediocre pretax margin.

To speed up the analysis and screening process, IBD has the . It combines readings on sales, profit margins and return on equity into a letter grade of A to E. Prefer stocks with an A or B. Some turnarounds may have poor SMR grades that improve over time.

The SMR rating is found in IBD's Smart Tables, stock quotes at Investors.com and in other features.

Profit margin basically tells how much profit has been produced from each dollar of sales. The more profit a company squeezes out of its sales, the better off the business is. Margins can tell investors whether a company is getting squeezed by costs, if it shows solid pricing power, or if it's pumping even more profit through larger sales.

In general, look for a company whose margins are among the best in its industry, are near its peak, and are ideally improving. Don't compare the margins of one company with those in different industries; they vary from industry to industry.

IBD calculates annual pretax margin by dividing income over the past year from continuing operations by sales over the same time frame. IBD calculates quarterly after-tax margin by dividing earnings, excluding extraordinary items, by quarterly sales.

Return on equity helps understand how well a company manages shareholder capital.

"If a company achieves a high ROE that means they are increasing their net profit and the worth of the business (shareholder's equity)," Charles S. Mizrahi wrote in "Getting Started in Value Investing." "When the net worth of the company rises, shareholders will be rewarded with a higher share price.

For return on equity, IBD divides net income for the past fiscal year by the average of shareholder equity over the past two years. Winning stocks tend to have ROE of 17% or higher. Be aware that a high amount of long-term debt can indirectly inflate return on equity because debt reduces shareholder equity.

At Investors.com, the in-depth stock quotes and provide subscribers with the most recent numbers on margins and return on equity. Use these online tools to compare a company against its rivals. For example, try comparing numbers among the Group Leaders table on the Stock Checkup.