Whether a company is a good long-term investment usually comes down to both qualitative and quantitative factors. Using multiples can be an important quantitative tool to ensure you don’t overpay for an investment.
What do a few other pieces of data tell us about stocks and can we glean a buy or sell signal from them? Today I’d like to discuss two metrics that may help interested readers analyse shares.
Return on equity
Return on equity (ROE) is a profitability ratio that is used to assess how efficient and productive a company is with its money.
The formula is derived by dividing a company’s net income by its share capital base. In other words, it measures how much a company is earning relative to the money it keeps within the business.
It is expressed as a percentage, such as 18%. That would mean that for every £1 worth of shareholders’ equity, the company has generated 18p in net income.
A higher ROE indicates that management is more effective at converting capital into profit. My own rule of thumb is to look for ROEs above 15% as I screen for investments. I’d also like to see that the company consistently provides a high return on equity over many years.
Investors may also use ROE to compare rivals in a given industry. So, all else being equal, a high ROE is better than a low one.
Consumer goods giant Unilever has an impressive ROE of 76%. By comparison, that of Reckitt Benckiser currently stands at 16%.
Debt-to-equity ratio
For most companies, debt is an important reality of running a business as they may need to borrow for a variety of reasons. Building or growing a business requires investment capital.
Therefore, looking at the ROE alone may not always always suffice, as high debt levels may boost a company’s ROE and give the illusion that the business is generating high returns.
However, debt may also mean increased level of risk for the company. With increased risk, investors would like to see increased returns.
If the cost of debt financing outweighs the increased returns generated, then investors may be alarmed and sell a company’s shares.
Investors therefore also need to look at the debt-to-equity ratio in order to ascertain if debt levels might be too high with respect to the share capital of the company. This metric is a leverage or gearing ratio that shows whether a company’s capital structure is tilted toward debt or equity financing.
It also varies across industries. A ratio of 0.75 means that creditors provide 75p for each pound provided by shareholders to finance the assets. A high debt-to-equity ratio generally means that a company has aggressively financed its growth with debt.
Unilever has a debt-to-equity ratio of 2.2. Thus it’s worth noting the significant use of debt by Unilever. Its high ROE has clearly benefited from the group’s use of debt.
Reckitt Benckiser’s debt-to-equity is about 1, which highlights that creditors and shareholders equally contribute to its assets.
The Foolish takeaway
So which company would be a better investment? Both have their supporters and the answer depends on several factors, including your personal risk/return profile and investment horizon.
Although ROE and debt-to-equity can be useful metrics, they are only a small part of diligent research. I’d encourage you to do further due diligence on both companies.