1 Way to Find Good Stocks Using The Return on Equity

What is a good stock?

The definition of it may vary from one person to another. However, from an investor’s point of view, it is a stock that has a track record of generating consistent profits in the past and can remain profitable in the future, regardless of the ups and downs of the economy.

So, how can we find a good stock?

There is a wealth of information on how to find one. Here, I would focus on using return on equity (ROE). So, let us just dive straight into the formula, then, I would explain how to use it to find good stocks for yourself.

The formula

ROE is calculated by dividing a stock’s annual earnings by its shareholders’ equity.

For instance, if a stock has $100 million in shareholders’ equity and it made $10 million in shareholders’ earnings, its ROE works out to be 10%. This means it has made $10 in earnings from every $100 in shareholders’ equity.

Now, let us get into the application.

Negative ROE

This arises when a stock incurred losses in a year. For instance, if a stock had $100 million in shareholders’ equity and incurred $10 million in losses, its ROE would be -10%. This means the stock has lost $10 from every $100 in shareholders’ equity. In this case, stock investors would avoid or dismiss the stock as an investment. Why take a chance on it when you can find many stocks that have positive ROE?

High ROE stocks are preferred

The primary objective of most stock investors would be to beat the inflation rate. Thus, in general, stocks with high ROEs are preferred over stocks with low ROEs as they are more efficient in using shareholders’ capital to make profits. However, of course, there is always an exception to this rule as it differs from industry to industry and one’s investment objective.

For instance, if you are investing for growth, you may want to focus on high ROE stocks. Why? This is because the company chooses to keep its earnings (which belongs to you) to invest for future growth. It makes sense to forgo your dividends if the company can reinvest your profits to expand its business for greater profits in the future.

However, if you are investing for dividends, it is okay to go with stocks that have lower ROE (but not below 5% as that is too low).

Let’s take a real estate investment trust (REIT) as an example. REITs are capital intensive and usually have under 10% in ROE. However, they pay out more than 90% of their earnings to you as a unitholder. So, if the price is right, the investment in a REIT makes sense if the dividends received far exceed the current fixed deposit rate.

ROEs must be stable

A stock is only good if its profits are stable. This is why we should look at a stock’s ROE over a period of five to 10 years as a test of consistency. In general, a stock may not be a good investment if its ROEs decline over the long-term.

However, if you can find a stock with stable or growing ROEs, then, you might have just gotten yourself a good stock.

The Foolish takeaway

In a nutshell, a good stock is one that has high and stable ROEs. Bad ones are those with negative ROEs, low ROEs or inconsistent ROEs. Most investors would disregard them as an investment, thus, reducing their risk of making poor investment decisions.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.