Best Stock Picks Must Consider This Important Financial Ratio

By: Zainul Anuar

Investors are trying their very best to make money in the stock market. But most forget to consider Return on Equity (ROE) quite seriously in their quest to find the best stock picks ever.

They are more concern with its popularity among media and analysts than the stock itself. Whenever the stock does not perform as expected, they start to blame others than accepting their own mistakes. Let see if ROE worth to be considered.

What is ROE?

ROE is the investment return that shareholders' fund is getting from the company's profits. It can be calculated as the ratio of company's net profit to the average shareholders' equity.

Shareholders' equity is the difference of the assets from its liability, which theoretically is something owned by the shareholders.

For example, ROE of 30 per cent shows that every $10 shareholders' fund in the company will generate $3 net profit in return. It can be explained as the shareholder's return on investment as well.

Why ROE is important?

Look, it is not difficult for the company to achieve the record earnings every year as they can easily earn five per cent return by putting it in cash deposit.

However, good management must use the retained earnings for a greater benefit. Besides, the earnings per share growth can be manipulated from the share buybacks.

On the other hand, ROE indicates how effective the company's management team is in managing shareholder's money. Great management has proven experience in performing 15 to 25 per cent ROE consistently over time. The higher the ROE, the less amount of money is needed to generate the same amount of profits.

Of course you want to invest in a company that can generate $10 million in profits from $50 million fund than the one that can only make $1 million profits from $100 million fund, don't you? I personally love these type of stocks so much.

Having said that, ROE can be manipulated as well. The company can made up their ROE to the attractive level by distributing dividends to its shareholders. Nevertheless, you can minimise the risk by investing in the company that has consistent high ROE.

After all, great investment should have good result consistently right?

After you have analyzed ROE, do not forget to use other financial ratios as well. EPSGR, D/E, liquidity ratio and ROA are proven to be useful in researching the stocks.

Other than that, analyze the stocks qualitatively as well.

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