There are many metrics out there worth paying attention to, but I think a severely underrated one is the return on equity (ROE). It is defined as net income divided by shareholder’s equity and is a measure of management’s efficiency in terms of what it does with the money that shareholders have invested in the company.
Competitive Advantage
Corporations with high ROE’s usually have some sort of competitive advantage which allows them to differentiate themselves from other companies. These are the firms that generate sustainable strong profit growth and cash flows, which leads to outsized gains in the stock. I love the fact that it is very easy to calculate and tells a lot about how management is performing.
A firm with a low ROE will need more capital from shareholders to generate any profit growth. This type of a business will not be successful over the long term, and is a value destroyer rather than a value creator. One way to interpret ROE is a speed limit as to how fast a company can grow its profits without raising additional money. This is key because money raises usually are costly and dilutive to existing shareholders.
One Caveat
Companies can juice up their ROE’s by leveraging themselves up with too much debt. These are the companies that you want to avoid. I like firms that have ROE’s over 20% without debt levels being burdensome. High ROE’s without high debt means that the return on equity is being generated by strong profit margins and asset turnover rather than leverage.
Here are two stocks with strong ROE’s:
Apple Inc. (AAPL) sports a huge ROE of 38.78% combined with no debt on its balance sheet. This company needs no introduction and the management has proven itself to be one of the best innovators in the history of corporate America.
Microsoft (MSFT) is another company that doesn’t need an introduction. It has an ROE of over 44% with a debt/equity ratio below 20%. Their business model is extremely efficient and generates tons of cash flow and utilizes shareholder’s equity very well.
Look For Companies With a Healthy ROE is an article from: 
