These Companies Are Achieving Impressive Returns on Equity and Reducing Debt

Rupert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When it comes to investing, obviously making money is key and the best way to make money is to find the most profitable company set to generate huge amounts of cash in the future. More cash usually leads to a higher stock price and a fatter bank balance means there is potential for dividend checks, windfall payouts, or other shareholder returns.

It is difficult trying to find these elusive companies, but through a combination of historic ratios and analyst predictions, I believe that I may have found several that are set to power forward with plenty of cash for the future.

As a starting point, I began searching for companies that had a good profit margin, in particular, an earnings-before-interest-and-tax margin of around 20%, which indicates a good flow of cash in to the company's coffers. Secondly, using historic figures, I started looking for companies that had achieved a five-year average return-on-shareholder-equity greater than 15%, to highlight the companies that had consistently delivered a good return on shareholder capital.

Lastly, I searched through analyst predictions and reports to whittle down the remaining candidates looking for companies that were predicted to improve their gearing ratio by at least 50% over the next three years. For example, a company's net debt to shareholder equity ratio should fall by 50% over the next three years, indicating improving free cash flow, fiscal prudence, and balance sheet strength.

Note: for the purpose of this piece, gearing is total debt divided by shareholder equity.

The results

First up is luxury jewelry producer Tiffany (NYSE: TIF). Tiffany has achieved a 15.9% return on shareholder equity on average during the past five years -- a consistent, high level of return. In addition, the company's earnings-before-interest-and-tax margin during 2012 was 18.7%, indicating a strong level of cash generation.

<table> <thead> <tr><th>Company </th><th> <p>EBIT margin, FY 2012</p> </th><th> <p>ROE 5-YR average </p> </th></tr> </thead> <tbody> <tr> <td> <p>Tiffany</p> </td> <td> <p>18.70%</p> </td> <td> <p>15.90%</p> </td> </tr> </tbody> </table>

From a gearing perspective, Tiffany's wide profit margin and strong return on equity mean that the company's level of gearing is projected to fall rapidly over the next few years. According to estimates, the company is expected to reduce its gearing by around 30% every year for the next five years, which should lead to a higher share price and more returns over the next few years.

<img alt="" src="http://g.fool.com/editorial/images/54513/1_large.png" />

Next up, biotechnology

Next is biotech company Merck (NYSE: MRK). Merck has recently fallen out of favor with investors after a poor first quarter but the company is still generating a lot of cash and producing a good return on shareholder equity. Over the past five years, Merck has produced an average return-on-equity of 16.6%, partly down to the company's wide EBIT margin, which came in at 22.2% of revenue during 2012.

<table> <thead> <tr><th> Company</th><th> <p>EBIT margin, 2012</p> </th><th> <p>ROE 5-YR average </p> </th></tr> </thead> <tbody> <tr> <td> <p>Merck</p> </td> <td> <p>22.20%</p> </td> <td> <p>16.60%</p> </td> </tr> </tbody> </table>

With such a wide EBIT margin, Merck has a strong cash flow and analysts predict that the company's gearing level will turn negative (move into a net cash balance) this year. Indeed, the company's wide profit margin means that even after losing the exclusive manufacturing rights to some of its key drugs, it is still set to churn out cash for the next few years, which will open the door to additional stock repurchase programs like the $5 billion buyback that the company has recently announced.

<img alt="" src="http://g.fool.com/editorial/images/54513/2_large.png" />

And finally

Lastly, medical device manufacturer Zimmer Holdings (NYSE: ZMH), which, thanks to the extremely defensive and specialist nature of its operations, has an EBIT margin of nearly 30%. The company's return-on-equity has been 12.9% on average for the last five years -- lower than the other companies in this piece, but with debt set to start falling in 2014, this figure should rapidly improve.

<table> <thead> <tr><th> Company</th><th> <p>EBIT margin, 2012</p> </th><th> <p>ROE 5-YR average </p> </th></tr> </thead> <tbody> <tr> <td> <p>Zimmer Holdings</p> </td> <td> <p>29.70%</p> </td> <td> <p>12.90%</p> </td> </tr> </tbody> </table>

<img alt="" src="http://g.fool.com/editorial/images/54513/3_large.png" />

Zimmer's gearing is forecast to double this year, however, the company is set to get back on-track during 2014, with analysts predicting that gearing will fall to (2)% (net cash position), followed by a fall to (9)% in 2015. With Zimmer moving into a net cash balance, investors could be in line for cash returns and a rising stock price akin to the rest of the medical and biotechnology sector.

Conclusion

Overall, these three companies are all producing a strong level of return on equity and have wide profit margins. Additionally, thanks in part to their wide profit margins, gearing and debt is set to fall rapidly over the next few years, which will hopefully lead to financial stability and security to investors knowing that the companies have a solid balance sheet to back up expansion or provide security in times of stress.

The best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.


Fool contributor Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool owns shares of Zimmer Holdings. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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