Stock Research Checklist – Equity

Return on Equity is how much profit the company is generating with the shareholder’s money. As a shareholder, you can earn lot of money over time with a company that has a high ROE.

What is the Company’s ROE for the last 10 years? Does it trend upward?
ROE = Net Income / Share Holder’s equity

In EPS, management can do financial engineering to increase the figure over time, without increasing the earnings. If they buy back shares, which causes the EPS to increase. Buying back shares is a good thing for the company and shareholders but the intention to increase the EPS is not good enough. If the company uses more debt, it can generate a higher ROE. Generating a high return on equity with reasonable debt is a good thing.

Does the Company have more equity when compared with Long Term Debt?
Debt-to-equity ratio is one of the most important figures to examine. You need to look for companies with more equity than debt. That kind of company has a strong balance sheet, and investors do not need to worry about leverage problems. This kind of company makes more money for long-term shareholders.

When a company has more debt than equity, especially when the economy starts to slow, the company may feel financial pressure to make the interest payments or run the risk of violating the financial covenants. Situations like that quickly reduce stock prices, and long term shareholder values can be destroyed in short period of time. When a company uses leverage, it can generate more revenue and that revenue flows to the bottom line as earnings. If those extra earnings are sufficient enough to service the debt, pay down the principal debt balance and also add more earnings to the company, that is good.

If company has enough cash to cover the short-term debt, we can omit the short-term debt and use the long-term debt as the debt for calculations . Debt and equity ratio varies for different industries.

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