Five Highly Profitable Companies to Consider
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The ROE – return on equity - ratio is a very important metric to keep in mind when selecting stocks for the long term. It's calculated by diving net income over shareholders' equity, and it measures the ability of a company to generate earnings with each dollar of investors' capital.
Like the name implies, shareholders' equity represents the part of the company's assets that belongs to its owners as opposed to different kind of creditors. The importance of generating higher earnings for each dollar of shareholders capital is easy to understand from an intuitive point of view.
Let's assume we have two businesses; one of them generates $10 dollars for each $100 of capital – a ROE of 10% - and another one with a ROE of 20% generating $20 for an investment of $100 in shareholders' equity. If the company with the higher ROE ratio can keep reinvesting earnings at high profitability rates, those earnings will grow much faster than in the first example.
Alternatively, if the more profitable company can't reinvest in opportunities with enough profitability, it can distribute a higher proportion of those earnings to shareholders via dividend payments or share buybacks. High ROE companies usually generate bigger cash flows, and they can reward shareholders with higher growth rates and/or bigger cash distributions.
Microsoft (NASDAQ: MSFT) is one clear example of a big and stable company with an outstanding ROE of 38.2%. The software business requires little amounts of capital to generate sales and earnings, so Microsoft is able to operate with high levels of profitability. As the company became bigger with time, it started distributing cash to its investors in 2003, and shares of Microsoft currently yield 2.6% in dividends.
Many people started questioning Apple (NASDAQ: AAPL) when it decided to pay a dividend and implement a share buyback program in March of this year, claiming that it was becoming a slow growth company just like Microsoft. But that assessment doesn't make much sense once we take a look at the company's financials and business fundamentals.
The estimated cost of Apple's cash distribution policies is around $45 billion in three years and the company generated $17.5 billion in cash flows from operations in the last quarter alone. Considering that Apple doesn't usually do big acquisitions and the business has a ROE ratio above 40%, the company is profitable enough to compound earnings at extraordinary growth rates while at the same time distributing cash to shareholders without limiting growth opportunities.
High-growth enterprises like Baidu (NASDAQ: BIDU), the Google of China, usually have extraordinary ROE ratios -- in Baidu's case it generates more than 55% in Return on Equity. Online advertising is a high growth business, and China is a high growth country, which explains how Baidu is able to sustain such a high profitability, which has been translated into an earnings growth rate above 85% annually over the last five years.
High ROE companies can also be found in the healthcare and biotech sectors, which provide ample opportunities for value added innovation and above average profitability. Gilead Sciences (NASDAQ: GILD) for example, has a ROE ratio in the 39.5% zone. The company has successfully produced and marketed many important medicines for HIV treatment in the last years, and that has generated an average growth rate of almost 23% in earnings per share in the last five years.
But profitability is not only about certain industries or business sectors. Once you find a company that has much higher profitability ratios than its competitors you know you've found a firm with a solid competitive advantage. Ross Stores (NASDAQ: ROST) has a ROE of 46.5%, while other fashion retailers don't usually pass the 20% mark.
Ross Stores has generated a very strong competitive advantage by sourcing smartly for low priced merchandise and translating those cost savings to customers. Not only shoppers, but also shareholders have benefited from this intelligent strategy. Over the last five years Ross Stores has delivered and earnings growth rate of 27.4% annually and its shares have gone from around $7 in 2007 to more than $62 currently.
No financial metric avoids the necessity to analyze the qualitative aspects of a business, like competitive advantages or the quality of the management team. However, when looking for companies with the best prospects to produce above average returns for investors in the long term, the ROE ratio can be one of the most powerful figures to consider.
acardenal owns shares of Apple. The Motley Fool owns shares of Apple, Baidu, and Microsoft. Motley Fool newsletter services recommend Apple, Baidu, Gilead Sciences, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.