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Financial Literacy

Return On Equity (ROE): Find Explosive Momentum Stocks With This Financial Ratio

Return On Equity (ROE): Find Explosive Momentum Stocks With This Financial Ratio

by Dr. Scott Brown, Education Director, Investment U
Tuesday, June 2, 2009: Issue #1009

Green Mountain Coffee Roasters produced a return of over 113% this year alone. When powerful momentum stocks are charging upwards, it can be difficult to know when to get on board.

But it’s not as difficult as you would believe.

If you want the inside track on the best momentum stocks with ultra-explosive gains, throw on your “x-ray glasses” and focus on one of the most useful financial ratios around.

It’s called return on equity (ROE), but in many ways it tells us so much more.

ROE is one of the best measures of a corporation’s profitability. It shows you how much profit the company generates with the money shareholders have invested. Let me show you how to easily pull this number out – and how profitable it can be.

How to Calculate Return On Equity (ROE)

You calculate return on equity (ROE) by dividing net income by a shareholder’s equity. The higher the number, the more effective a company is at turning its assets and employees into piles of money for investors.

For instance, between 1998 and 2003, Dell Computer’s highly efficient direct sales and high profit-margin strategy paid off in terms of strong earnings growth and a double-digit ROE of 46%. During that same period Dell shares soared 91.95% raining money on shareholders.

ROE explains why Green Mountain Coffee Roasters (Nasdaq: GMCR) posted a 92.86% return while the S&P500 tanked, -34.37%, over the last year. It’s been a horrific time for most investors, but GMCR shareholders have had lots to smile about as management skillfully squeezed out a 27.85% return on equity.

It’s made Green Mountain one of the few really safe harbors for the investors to ride out the market’s “storm of the century.”

The ROE ratio looks like this:

The Return on Equity Ratio (ROE) Breakdown

The only way this ratio can stay high or increase is by maintaining or increasing the bottom line net income through good management. If executives try to hose investors by sucking profit away – issuing more shares through a seasoned equity offering – you’ll catch them by the drop in this ratio.

Other investors who solely focus on net income won’t know the jig is up, because it will stay the same. That’s why ROE is a much better indicator of management effectiveness at bringing home the bacon.

How to Track Return On Equity (ROE)

Return on equity (ROE) is easy to track through many free financial websites – I like to use Yahoo! Finance. First, type the stock symbol of the company you’re looking for into the “Get Quotes” form on the upper left part of the web page.

When the page for the company’s information comes up, click on the “Key Statistics” link. Then on the same page in the “Management Effectiveness” section you’ll see the value for “Return on Equity (ttm).” This tells you how well management is generating profits for shareholders.

Just look at how their shares have soared…

GMCR's Return On Equity Chart from Yahoo Finance

We can also pull up the amount of institutional shareholders of this company. One of the other interesting things we can access on Yahoo! is the amount of institutional ownership of GMCR. Today it’s almost 27.85% of the company shares.

Institutions are some of the biggest drivers of price movements on the markets and a low institutional ownership means that this stock could have much more to go. By comparison, Starbucks has an institutional ownership of 66% – and a ROE of 3.47%.

Return On Equity (ROE) – How Well Is Management Doing?

Quite simply, a higher return on equity (ROE) number tells us how well management is doing, and if a company is undervalued.

It’s imperative you watch closely how ROE changes over time – ideally you want it to increase. Print off and save the Yahoo! Finance web page for “Key Statistics” each week and you’ll see for yourself how return on equity is changing. If return on equity is double-digit and increasing you might want to consider buying the stock.

If a momentum stock like Green Mountain keeps on increasing its ROE, the stock should continue rising as well. So watch for the new ROE numbers for GMCR on June 28.

It all starts with education,

Dr. Scott Brown

Today’s Investment U’s Crib Sheet – Word of the Day

Accounting Earnings

Definition: Accounting earnings are the actual income of a company as stated on their income statement. Earnings estimates can be altered and finagled in the much the same way a company can alter their earnings per share by changing the amount of shares

Progress On the Way…

We’re in the process of updating our Investment U glossary and additional educational content on our site. Look to see the new improvements by the end of the summer.

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