The Return on Equity (ROE) is a measure of profitability that looks at how much shareholders earn for their investment in a company. Warren Buffett sees companies with above-average ROE as positive signs for investment. A higher ROE is generally better, with figures above 15% considered good and above 20% exceptional. However, comparing ROE with industry averages is essential to understand a company’s performance accurately.
ROE can be broken down into three components: net profit margin, asset turnover, and financial leverage. The net profit margin reflects a firm’s efficiency in generating profit for a given level of sales. Asset turnover measures how well a company uses its assets to generate sales. Financial leverage indicates the level of debt a company has relative to equity and affects the return on equity. Ideal firms maintain high profit margins, efficient asset usage, and low financial risk.
The AAII Return on Equity screen aims to identify companies with consistently high ROE that outperform their industry peers. The screen looks for companies with an ROE 1.5 times their industry median over the last 12 months and previous five fiscal years. Companies passing the screen must also have net profit margins, asset turnover, and financial leverage exceeding industry medians to ensure profitability, efficiency, and acceptable levels of risk.
Stocks passing the Return on Equity screen are ranked based on their ROE, profitability, efficiency, and leverage. The screen requires firms to have positive earnings and sales growth over the past 12 months and historical growth rates exceeding industry medians to ensure some level of growth. Additionally, stocks must be listed on an exchange to ensure trading liquidity and exclude OTC stocks, REITs, CEFs, and ADRs due to their special nature.
The stocks that meet the criteria of the approach do not represent a “recommended” or “buy” list, and it is essential to conduct due diligence before investing. By becoming an AAII member, investors can gain an edge in navigating market volatility and accessing resources to make informed investment decisions. The AAII Return on Equity approach provides a systematic strategy to identify companies with strong profitability, efficiency, and growth potential.
