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Feb 1, 2024

Key Metrics: Return on Equity

by Mystery Manager

For any investor, navigating the vast ocean of stocks can feel daunting. Amidst a sea of numbers and charts, finding hidden gems requires understanding some key metrics, and one crucial metric is Return on Equity (ROE). But why is ROE so important, and how can it guide your investment decisions? 

In simple terms, ROE measures how effectively a company generates profits from shareholders' investments. It is calculated by dividing the company's net income by its shareholder equity, expressed as a percentage. Essentially, a higher ROE indicates that the company is better at turning investors' money into profit.

Let's look at why understanding ROE is crucial:

1. Gauge Profitability and Efficiency

A high ROE suggests strong earnings power and efficient management. By analyzing a company's ROE over time and comparing it to competitors, you can determine its profitability and gauge its ability to generate sustained returns for shareholders.

2. Evaluate Investment Potential

Comparing a company's ROE to its dividend yield can reveal valuable insights. For example, a company with a high ROE and low dividend yield might reinvest its profits in future growth, potentially leading to higher stock prices in the long-run. Conversely, a low ROE and high dividend yield might indicate stagnant growth or unsustainable payout practices.

3. To Identify Potential Red Flags

While a high ROE is generally desirable, it's crucial to analyze the underlying factors. An unusually high ROE achieved through aggressive accounting practices or excessive debt financing could be a red flag, leading to volatility and future financial difficulties.

Now, let's put theory into practice by examining three Canadian stocks with varying ROE values:

Shopify (SHOP)

While this e-commerce giant is considered a growth stock (which has more than doubled since the beginning of 2023), it has a history of showing quarters of ROE as high as 30-40%. This reflects the company's potential to be a profitable business and use its efficient business model and strong brand recognition to generate profits and continue to grow its user base. While ROE has admittedly been patchy and even negative at times, you could think of this as a “hint” for consistently high ROE in the long run, especially given its lean nature as a technology business.

Canadian Natural Resources (CNQ)

This energy giant has a moderate ROE of around 18%. CNQ generates strong cash flow, but its ROE can fluctuate with commodity/oil prices. What is notable about CNQ's ROE vs Shopify's is that it is more consistent over time. It is also generally higher than its oil peers at any point in time. Investors seeking income might find its high dividend yield attractive, while others might look for companies with steadier ROE growth.

Air Canada (AC)

This airline has experienced significant financial turbulence in recent years, resulting in a negative ROE. In addition, AC's American competitors have shown a better recovery in profits and ROE, indicating that competition has played a healthy role for U.S. airlines, while AC's monopoly position in Canada may result in a slower recovery. In fairness, the negative ROE is also related to a negative equity position the company has been in over the last few years rather than a lack of profits, and it is worth noting AC has recently regained a positive equity position on its balance sheet. While AC might hold potential for turnaround plays, investors should be cautious due to the inherent risks of recovering airlines and potentially negative returns in the short term.

These examples illustrate how ROE can provide valuable insights into a company's financial health, its growth potential, and its suitability for different investment strategies. Remember, ROE should not be used in isolation; consider other financial metrics, industry trends, and overall economic conditions to make informed investment decisions.

By decoding the language of ROE, you gain a powerful tool to navigate the stock market and unlock potential opportunities. While not a crystal ball, ROE can act as a compass, guiding you toward companies that efficiently utilize resources and reward their shareholders with sustainable returns. So, the next time you encounter a stock, remember to ask yourself: what story does its ROE tell?

Mystery Manager

Disclosure: The author(s) responsible for this article do not have a financial or other interest in the securities mentioned.