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Sizing up a Stock's Return
In order to evaluate a company’s profitability, equity investors will often look at various ratios that measure the return on investment that a business generates. These ratios tell investors about the earning power of a company. There are several ways to measure this concept; we will focus on two: Return on Shareholders’ Equity and Return on Total Capital. Return on Shareholders’ Equity is computed by taking Net Profit and dividing it by Net Worth, which is the difference between total assets and total liabilities. Return on Total Capital takes Net Profit and adds in Long-Term Interest (adjusted at the company’s current tax rate) divided by Net Worth as well as the company’s Long-Term Debt. These ratios are located at the bottom of the array on the Value Line page. Trends in these measures can tell a lot about a company’s performance and the skill of its management team. On point, a rising (falling) trend indicates a company with a return on investment that is improving (weakening).
Return on Shareholders’ Equity measures a company’s profitability and shows how much of the profit was derived from money invested by shareholders. This ratio reveals how much has been earned, in percentage terms, for the stockholders. Higher figures are generally desirable, often indicating greater productivity and efficiency. Further, this ratio takes into account both financial leverage and the efficiency of assets. Accordingly, the return on stockholders’ equity calculation provides an investor with information on what profits will be accruing to the equity base.
Return on Total Capital measures the percentage a company earns on its shareholders’ equity and long-term debt obligations. This ratio eliminates the effects of financial leverage and, as a result, generally provides a strong measure of a company’s operating performance. When a company’s Return on Total Capital goes up, there should also be an increase in the Return on Shareholders’ Equity. That’s because management is normally able to earn a higher rate on its long-term borrowings than it pays out in interest expenses. If not, it simply means that the company is borrowing more and paying greater interest but is not earning more for the stockholders on their equity in the company’s assets. Unless a company can earn more than the interest cost of its debt over time, the risk of borrowing is not worthwhile. What’s more, another warning signal investors should watch out for is when the Return on Shareholders’ Equity drops below the Return on Total Capital. This means that earnings on investments funded with borrowed money are not covered by the debt interest payments.
Investors should look for return on investment ratios above the company’s industry average. This would suggest a company is reinvesting its cash at a higher rate of return than its peers. Additionally, if earnings climb while these ratios decline, it may indicate that the company is having trouble finding attractive investment opportunities for its capital. It may also mean a company is aggressively investing for the long haul, which would mean it may take some time before the company profits from its investments.
Investors usually prefer stocks of businesses that utilize capital the most efficiently. As a result, these two ratios are widely watched. An investor who can identify companies that generate good returns on their assets will often find equities that are well positioned to advance in the future. All in all, analyzing these ratios should comprise just one part of an investors’ stock analysis.