Value Line is regarded as the best independent research available. More than just recommendations, Value Line provides the rationale behind its picks for greater understanding.
- Don D., California
Stock Screen: High Returns Earned on Equity – October 29, 2010
When an investor buys shares in a company, he or she is buying a portion of that enterprise. In fact, the whole idea behind investing in stocks is that the management team of a selected company can make better use of an investor’s resources than the investor can, and, thus, earn a return for the investor in the form of distributions (normally dividends) or a higher stock price. It can be difficult, however, to get a clear picture of how well a company makes use of the resources provided to it by shareholders.
One quick way to cut through the large number of investments available is to review returns on equity. Value Line calculates this number, which appears in the Statistical Array on every research report, by dividing net profits by shareholders’ equity (equity, or net worth, itself, is equal to the difference between total assets and total liabilities). The general idea of the measure is to see how much a company earns on the money it has been given by equity investors. (This total includes preferred stock.) Companies with high scores on this metric are, presumably, better wards of capital
To create our list, we first screened for companies ranked 3 (Average), or higher, for Timeliness (i.e., relative price performance in the year ahead), one of Value Line’s many proprietary measures. Next, we computed the average percentage earned on shareholder equity by each company over the last five years for which we have actual data, and set a floor for the measure at 28.5%.
Investors should be aware that the use of a five-year average tends to favor consistent earners of substantial returns on common equity over companies that have just recently experienced recoveries. And a focus on share equity, rather than total capital, helps identify firms that have used debt and, thus, have successfully employed financial leverage. Indeed, comparing this measure to return on total capital (calculated by dividing net profits plus half of the current year’s long-term interest due, by the sum of shareholders’ equity and long-term debt) can provide insights into how well companies are making use of debt—if return on total capital rises, but return on shareholders’ equity doesn’t, additional debt financing may not be benefiting shareholders.
That said, this measure is best used as a starting point and a comparison tool. Some industries will never show up on a screen of this nature, others will have many representatives. Thus, comparisons between companies in the same industry will provide more insight than comparisons between companies in different industries. Below are some highlights from our screen:
International Business Machines (IBM – Free Analyst Report) is a global manufacturer and developer of information technology (IT) products and services worldwide. The company operates in six segments: Global Technology Services (39% of 2009 revenue), Software (22%), Global Business Services (19%), Systems and Technology (17%), Global Financing (2%), and Other (1%). Research, development, and engineering costs amounted to 6.1% of revenues last year, while foreign sales accounted for 64% of sales.
The technology bellwether is poised to benefit from improvements in information technology spending. The company earned $2.82 a share in the third quarter, an 18% increase over the year-earlier figure. Value Line analyst Theresa Brophy expects full-year earnings to be about $11.40 a share, indicating a $4.00-a-share profit during the final quarter of 2010. Economic challenges aside, IBM should realize double-digit bottom-line growth over the next two years, and it will likely continue to invest a portion of its gains in business growth, while also returning money to shareholders.
The company is doing this in different ways. First, it consistently introduces a plethora of new products or makes improvements to existing technology platforms in order to keep up with current technology trends. This should, in turn, facilitate top- and bottom-line expansion. Second, the company recently announced a new $10 billion share repurchase program, and we would not be surprised to see additional funds set aside for this purpose next year. Additionally, annual dividend increases are the norm, supported by a healthy balance sheet.
H.J. Heinz Company (HNZ) manufacturers and markets food products for households, as well as foodservice and international customers. It produces ketchup, condiments and sauces, frozen foods, soups, and baby food, to name a few products. Major brands include: Heinz Ketchup, Classico Pasta sauces, and Ore-Ida frozen potatoes. The company operates in four segments: Ketchup and Sauces (42% of 2009 sales), Meals and Snacks (41%), Infant/Nutrition (11%) and Other (6%).
Heinz will likely squeeze profits from emerging markets. The company is focused on the vast potential of countries like China and Russia (one of the largest ketchup-consuming countries in the world) as growth catalysts. Since China’s ketchup consumption is not as high proportionately, Heinz is seeking deeper market penetration in other ways. For example, it is in the final stages of purchasing Foodstar, a soy-sauce manufacturer, for $165 million. Acquisitions and product expansion in foreign countries should enable the company to realize its goal of having emerging markets account for around one-quarter of its total sales by mid-decade. Emerging markets should help the company realize solid share-net gains over the next two years. And although the North American market is saturated and highly competitive, the company is focusing on product innovation as a way to expand its business. For example, Heinz intends to introduce its “dip and squeeze” ketchup, aimed at fast-food channels, sometime next year. In terms of returning money to shareholders, Heinz offers regular dividend payments, which have increased every year since 2003.
GlaxoSmithKline (GSK), along with its subsidiaries, is a major U.K.-based research-based drug company. Its prescription medications treat a wide range of conditions including depression, asthma, and influenza. North American sales accounted for 40% of 2009 revenues, and research and development expenses amounted to 14.1% of sales last year.
Earnings growth may well slow a bit over the 3- to 5-year period. The company has recently faced a product recall for Avandia, Glaxo’s top-selling diabetes drug. Avandia has been pulled from European shelves and prompted stern FDA warnings to users. But sales of the drug were expected to taper to about 4% of revenues in 2012 when its patent expires, therefore, posing no significant hurdle. However, short-term growth may still be hampered because other brand-name drugs are nearing their patent expiration. Patent and legal issues aside, the company’s research endeavors will likely remain healthy. Such actions should, in turn, lead to new products, which ought to fill the void of expired ones. In addition, the company makes good use of its ample cash through acquisitions. The stock may appeal to income-oriented investors since it pays a handsome dividend to its shareholders.
To see the results of our screen, limited to those stocks that carry Above-Average scores for Timeliness, subscribers can click here. As always, subscribers should carefully review the analyses in Ratings & Reports before committing funds to any particular equity.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.