I’ve mentioned before on this blog about how important a good Return on Equity is, and while most people know and agree that it’s important and should be one of the key fundamentals that you look at when trying to decide which company to invest into, what you really probably want to know is, does a high return on equity mean the stock price will rise and it will be a profitable investment?
The answer isn’t as simple as just yes or no, because as you probably know there are many other factors as to whether a stock price rises or falls. Return on Equity is only a one of several factors that you should consider when choosing which company to put your money into.
So let’s look at three of the companies within the DJI that have the highest return on equities and compare that to the share prices over the last twelve months to see what has happened.
The three highest ROE’s in the Dow are Boeing with 88.36%, IBM with 69.26% and Microsoft with 44.84%.
If we look at their charts below for the past twelve months we can see that only one of them (IBM) has increased substantially over this period with a 31.54% increase. Boeing decreased by -4.77% and Microsoft increased slightly by 2.87%.
Therefore on the whole it doesn’t seem if just looking at return on equity equals a rise in share price.
So if a high ROE DOESN’T correlate to a stock price increase why is it important?
It’s good because it indicates how much surplus funds that the company has that it can invest back into the business without having to borrow more. A company with a lot of debt can be risky, and generally I will only invest in companies with debt to equity levels less than 75%, so if a company is able to finance its growth and expansion WITHOUT having to borrow more money (by using the profits it makes instead) then it makes it stronger and more stable.
A stronger and more stable company has the POTENTIAL to earn more money for stock holders over the long term. It’s better able to ride out stock market fluctuations and over a longer period provide a good return for investors.
So let’s look at again at the three companies above over a longer period of time so that we can really get a good idea of whether you’ll make money over the long term.
All of the companies (even though Microsoft has slowed down dramatically since 2000) have risen in price.
So does that mean over a longer period of time that the stock price will rise with companies with high ROE’s?
Maybe. If you look at most stocks, and especially those high cap blue chips that I prefer to invest in, then you’ll see that nearly all of them rise over the long term.
However your chances are MUCH better if you choose those with strong fundamentals over those that don’t.
Why risk your money with something that seems too good to be true on paper when you can choose something with a proven history of return with good financials.