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Editor's note: We have a special edition of DailyWealth for you today… This week, we've been running a series from master value investor Dan Ferris. So far, Dan has shared four of his five financial "clues" for finding great investments. You'll find the final – and most important – clue today…
If You Only Look at One Number Before Buying a Stock, Look at ThisBy
Saturday, September 28, 2013
Investment analysis is often a very complicated process, which you can't boil down to a single number...
But I've found the next best thing. And it's the final "clue" I look for in a great investment.
I've already shown you four other clues to look for. In short, I like companies that gush free cash flow… reward shareholders… have great balance sheets… and earn consistent profit margins...
And today, I'm going to share a clue that, in some ways, I think is the most important clue of all...
I'm talking about return on equity.
What do I mean by "return on equity"?
Well – if owning a stock were like owning a bank account, then return on equity would be the interest rate you earn.
There are two parts to this: the equity and the return.
Equity is net worth.
It's the value the owner of an asset or a business sees after all the obligations are met.
For example, say you own a $600,000 house, and you have a $400,000 mortgage on it. Your equity is $200,000. That's what the house is worth to you, the owner, after you meet all the obligations on it.
It's the same with a business in the stock market. A business has obligations to suppliers, employees, taxing authorities, utility companies... and many others.
To calculate your equity in the business, you add up what all the assets are worth and then subtract all those obligations from that total... just like in the example of a house.
Whatever is left over is called net worth, or equity.
You can find equity – called "shareholder equity" – on the latest balance sheet of any publicly traded company.
So that's the "equity" part of "return on equity."
The return part is the earnings of the business – called "net income" on the income statement of publicly traded companies.
For example, Wal-Mart's latest balance sheet says its shareholder equity is roughly $76 billion. That's what you get when you subtract the value of all Wal-Mart's financial obligations (its liabilities) from the value of its assets.
Over the last four quarters, Wal-Mart's net income was $17 billion. So $17 billion of net income, divided by $76 billion of shareholder equity, equals a 22% return on equity.
Imagine having a bank account that pays you 22% interest!
A high return on equity signals a great business – not just because it means you're making more money, but because of how it affects the second clue I showed you: rewarding shareholders.
Consider Wal-Mart again...
It can't reinvest 100% of its earnings at 22% returns.
That's why it pays out lots of cash in dividends and share buybacks – which is what helps you, the shareholder, get rich over time.
Here's just a handful of some of the investments I've found in Extreme Value. Each of these businesses had a large return on equity when I found them... AB-InBev is up 114%, Philip Morris International is up 105%, and Constellation Brands is up 171%.
Bottom-line: Return on equity is one of the great secrets of financial analysis.
Good investing,
Dan Ferris
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