Value Line is regarded as the best independent research available. More than just recommendations, Value Line provides the rationale behind its picks for greater understanding.
- Don D., California
Stock Screen: High Returns Earned on Equity - July 6, 2011
When an investor buys shares in a company, he or she is buying a portion of that enterprise. In fact, the whole idea behind investing in stocks is that the management team of a selected company can make better use of an investor’s resources than the investor can, and, thus, earn a return for the investor in the form of distributions (normally dividends) and/or a higher stock price. It can be difficult, however, to get a clear picture of how well a company makes use of the resources provided to it by shareholders.
One quick way to cut through the large number of investments available is to review returns on equity. Value Line calculates this number, which appears in the Statistical Array on every research report, by dividing net profits by shareholders’ equity (equity, or net worth, itself, is equal to the difference between total assets and total liabilities). The general idea of the measure is to see how much a company earns on the money it has been given by equity (including preferred equity) investors. Companies with high scores are, presumably, better wards of capital.
To create our list, we first screened for companies ranked 3 (Average), or higher, for Timeliness (i.e. relative price performance in the year ahead), one of Value Line’s many proprietary measures. Next, we computed the average percentage earned on shareholders’ equity by each company over the last five years for which we have actual data, and set a floor for the measure at 28.5%.
Investors should be aware that the use of a five-year average tends to favor consistent earners of substantial returns on common equity over companies that have recently experienced recoveries. And a focus on share equity, rather than total capital, helps identify enterprises that have used debt and, thus, have successfully employed financial leverage. Indeed, comparing this measure to returns on total capital (calculated by dividing net profits plus half of the current year’s long-term interest due, by the sum of shareholders’ equity and long-term debt) can provide insights into how well companies are making use of debt—if return on total capital rises, but return on shareholders’ equity doesn’t, additional debt financing may not be benefiting shareholders.
That said, this measure is best used as a starting point and a comparison tool. Some industries will never show up on a screen of this nature, others will have many representatives. Thus, comparisons between companies in the same industry will provide more insight than comparisons between companies in different industries. Below are some highlights from our screen:
Gilead Sciences, Inc.
Gilead Sciences (GILD) is a leading biopharmaceutical company with the goal of caring for patients suffering from life-threatening diseases worldwide. Gilead receives around 80% of its revenues from drugs used in the treatment of HIV/AIDS, with the rest coming from medications that help combat liver disease, respiratory ailments, and cardiovascular/metabolic difficulties.
Although HIV and AIDS awareness has arguably declined in certain countries of late, partly due to the effectiveness of drug regimens, the AIDS epidemic continues to spread, particularly in poorer African countries. Gilead has highly specialized expertise in this market, which is known for its high barriers to entry. Currently, the investment community is awaiting the arrival of Gilead’s QUAD product, a once-daily pill that contains four HIV drugs, and is in Phase III of clinical trials. Even though the approval process is progressing well, Value Line analyst Jeremy Butler doesn’t expect commercial deployment until 2012.
In the meantime, we think Gilead’s return on equity will remain north of the 40% mark. The company’s portfolio of in-house and acquired medicines is quite strong, and we believe it will lead to decent earnings growth in the coming quarters.
Cracker Barrel Old Country Store, Inc.
Cracker Barrel (CBRL) is involved in the operation and development of the Cracker Barrel Old Country Store restaurant and retail concept. It currently boasts 601 non-franchised locations in 42 states. The company has received a number of awards for customer satisfaction and food quality. For example, in 2010, The Good Sam Club named Cracker Barrel “The Most RV Friendly Sit-Down Restaurant in America” for the ninth consecutive year, and consumers who took restaurant reviewer Zagat’s survey voted it as having the best breakfast out of any full-service restaurant chain.
Cracker Barrel’s core customer base consists of relatively lower-income patrons who have been contending with higher gas prices and difficult employment conditions. This is part of the reason why near-term revenue growth may not prove particularly impressive. Still, Value Line analyst Justin Hellman expects unit development in non-traditional areas to help boost receipts. Too, the company has been combating food inflation with cost efficiencies. In all, we believe management’s solid execution will allow it to continue making good use of investors’ resources, despite economic headwinds.
VeriFone Systems, Inc
VeriFone Systems (PAY) designs, markets, and services merchant-operated and self-service point-of-sale (POS) electronic payment terminals for the financial, retail, petroleum, government, transportation, and healthcare vertical markets. VeriFone’s brand name, large footprint, and contributions to technological innovation have made it one of the largest providers of electronic payment systems worldwide. The United States and Canada accounted for 41% of revenues in the April quarter, while the International segment supplied the remainder.
The company is well situated to benefit from the global shift away from cash and checks towards credit and debit cards. Recently, growth rates in emerging markets have been higher than those realized, on average, by domestic enterprises, due to improving economic conditions, the relatively low penetration rates of electronic POS terminals, as well as governmental efforts to modernize economies and improve tax collection. Sales in developed countries have been helped by consumers' rising concerns that their retail transactions are not secure, as well as media terminals in taxi cabs, (particularly in the U.K.).
We expect the aforementioned trends to continue benefitting net income in the coming quarters. Too, the inclusion of near field communications technologies (allow consumers to pay for goods and services with their smartphones) ought to boost bottom-line results for several years, keeping this issue’s return on equity rather strong.
To see the results of our screen, limited to those stocks that carry Above-Average scores for Timeliness, subscribers can click here. As always, subscribers should carefully review the analyses in Ratings & Reports before committing funds to any particular equity.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.