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How to Increase Gains by Analyzing Returns
Posted by: Nelson Nguyen (IP Logged)
Date: July 26, 2014 10:44AM
Like in tennis, a good return is crucial to winning the game. Returns are a very important measure of a company’s financial health. Its history, trend and forward estimates will affect the stock’s price. Therefore, improving your Fundamental Analysis of a company’s Returns should help you increase gains from your investments.
Please note that you should compare the company’s return to its competitors', industry and sector when you are evaluating a company’s returns. Each company operates in a different industry and sector. Therefore results across different industries and sectors carry different risks, returns and averages.
Return on Equity (ROE):
If you had to teach a child about investment Returns, one of the first investing songs they may learn perhaps may be entitled, “ROE-ROE-ROE your Float.” All kidding aside, ROE is one of Warren Buffett (Trades, Portfolio)’s measures of a healthy company.
Return on Equity (ROE) measures the efficiency with which a company uses shareholders’ equity and is a great overall measure on returns on capital. (Note: A flaw in using ROE is a company can take on a lot of debt and boost ROE without becoming more profitable therefore you should look at Return on Invested Capital).
ROE = Net Income / Shareholder’s Equity
Analyzing ROE is the father of Return ratios. There is a method called DuPont Analysis that breaks down ROE into subcomponents to better analyze why and how a company’s ROE came about. In a future article, I will be writing about the DuPont Analysis, but for those interested in learning about it now you can find some information at the following:
Return on Assets (ROA):
Return on Assets (ROA) measures how much income a company generates per dollar of assets. Investopedia define ROA as follows: “An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's annual earnings by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as ‘return on investment’.”
ROA = Net Income / Total Assets
Return on Invested Capital (ROIC):
Return on Invested Capital (ROIC) combines the best in both worlds by measuring the return on all capital invested in the firm (both debt and equity). Does the company show a consistently high return on total capital (above 12%)?
ROIC = (Net Income – Dividends) / Total Capital
Return on Capital (ROC):
ROC = EBIT / (Net Working Capital + Net Fixed Assets)
EBIT is used because companies operate with different levels of debt and differing tax rates. By using EBIT, you can compare the operating earnings of different companies without the distortions arising from differences in tax rates and debt levels.
Net Working Capital + Net Fixed Assets (or tangible capital employed) was used in place of total assets (used in ROA) or equity (used in a ROE). Figures out how much capital is actually needed to conduct the company’s business. Net Working Capital is used because a company has to fund receivables and inventory. Net Fixed Asset is used because a company has to fund the purchase of fixed assets to conduct business (i.e. real estate, plant and equipment).
Return of Free Cash Flow (FCF) per Sales:
Free Cash Flow (FCF) = Cash Flow from Operations – Capital Spending
Return of Free Cash Flow (FCF) per Sales = FCF / Sales
Anything above 5% is doing a solid job at generating excess cash. Combining this ratio with ROE, you can divide companies into 4 categories.
Companies in Quadrant 1 are likely Wide Economic Moat companies; companies in Quadrants 2 and 3 are less desirable; while companies in Quadrants 4 likely the least desirable companies.
A healthy company will generate good returns. Understanding each of the Return ratios we discussed will help you better analyze a company’s historical Returns and ability to generate future Returns. As a result, I hope this will help increase the Gains to your investment portfolio.
Stocks Discussed: SPY, QQQ, DIA,