When you screen for stocks it’s natural to gravitate to using metrics like the price to earnings ratio, the price to book ratio, debt levels and net income. Those are all important metrics to consider, but you’re forgetting about one of the most important ratios of all – return on equity, or ROE.

ROE can be used to separate profit-creating companies from profit burners. Companies with a high ROE do a good job of extracting as much profit from their operations as possible – a feature that normally translates into superior returns for shareholders.

In short, teturn on equity is calculated by dividing the company's net income by its shareholder equity, or book value.

Return on Equity = Net Income / Shareholders' Equity

You can find net income on the income statement, but you can also take the sum of the last four quarters worth of earnings. Shareholders equity, meanwhile, is located on the balance sheet and is simply the difference between total assets and total liabilities. Shareholder equity represents the tangible assets that have been produced by the business.

Note that when calculating ROE, both net income and shareholder equity must cover the same period of time.

A company sporting a high return on equity implies that it is generating relatively high profits based on its invested capital. A company with $100 in income against $1,000 in shareholder equity has an ROE of 10%. A company that earns $200 against $1,000 in equity has a ROE of 20%, a more profitable business.

It’s worth noting that a company can boost its earnings or reduce its equity capital by taking on debt. Therefore, leverage can be used to boost a company’s ROE. In the rare instances where leverage makes sense, this is fine. However, when ROE is inflated because of leverage, ROE is not as desirable as it seems. The moral of the story is to pay attention to debt levels when examining ROE.

A company that consistently boasts above-average ROE could be the stock that you’ve been searching for. A company with a 10-year ROE of 20% means that for every dollar that the company invests in the business, it is earning $1.20. The secret to a top-performing company is one that takes the $1.20, invests it again at a 20% ROE, and continues doing this for years.

Microsoft used to be one such company. For over 20 years, Microsoft generated ROE in excess of 20%. Back in the 1980s, Microsoft could invest all its excess capital back into the business and earn the same high ROE.

To find companies with a competitive advantage, investors should probably use five-year averages of the ROEs of companies within the same industry. There may come a time, however, when a company cannot grow earnings faster than its current ROE without raising additional cash. That is, a firm that now has a 15% ROE cannot increase its earnings faster than 15% annually without borrowing funds or selling more shares.

But raising funds comes at a cost: servicing additional debt cuts into net income and selling more shares shrinks earnings per share by increasing the total number of shares outstanding. So ROE is, in effect, a speed limit on a firm's growth rate, which is why money managers rely on it to gauge growth potential. In fact, many specify 15% as their minimum acceptable ROE when evaluating investment candidates.

However ROE is not an absolute indicator of investment value. After all, the ratio gets a big boost whenever the value of the shareholder equity, the denominator, goes down. If, for instance, a company takes a large write-down, the reduction in income (ROE's numerator) occurs only in the year that the expense is charged; the write-down therefore makes a more significant dent in shareholder equity (the denominator) in the following years, causing an overall rise in the ROE without any improvement in the company's operations.

Having a similar effect as write-downs, share buy-backs also normally depress shareholders' equity proportionately far more than they depress earnings. As a result, buy-backs also give an artificial boost to ROE.

Moreover, a high ROE doesn't tell you if a company has excessive debt and is raising more of its funds through borrowing rather than issuing shares. Remember, shareholder's equity is assets less liabilities, which represent what the firm owes, including its long- and short-term debt.

So, the more debt a company has, the less equity it has; and the less equity a company has, the higher its ROE ratio will be.

Suppose that two firms have the same amount of assets ($1,000) and the same net income ($120) but different levels of debt: Firm A has $500 in debt and therefore $500 in shareholder's equity ($1,000 - $500), and Firm B has $200 in debt and $800 in shareholder's equity ($1,000 - $200). Firm A shows an ROE of 24% ($120/$500) while Firm B, with less debt, shows an ROE of 15% ($120/$800). As ROE equals net income divided by the equity figure, Firm A, the higher-debt firm, shows the highest return on equity. This company looks as though it has higher profitability when really it just has more demanding obligations to its creditors. Its higher ROE may therefore be simply a mask of future problems.

For a more transparent view that helps you see through this mask, make sure you also examine the company's return on invested capital (ROIC), which reveals the extent to which debt drives returns.

Another pitfall of ROE concerns the way in which intangible assets are excluded from shareholder's equity. Generally conservative, the accounting profession normally omits a company's possession of things like trademarks, brand names, and patents from asset and equity-based calculations. As a result, shareholder equity often gets understated in relation to its value, and, in turn, ROE calculations can be misleading.

A company with no assets other than a trademark is an extreme example of a situation in which accounting's exclusion of intangibles would distort ROE. After adjusting for intangibles, the company would be left with no assets and probably no shareholder equity base. ROE measured this way would be astronomical but would offer little guidance for investors looking to gauge earnings efficiency.

Let's face it, no single metric can provide a perfect tool for examining fundamentals. But contrasting the five-year average ROEs within a specific industrial sector does highlight companies with competitive advantage and with a knack for delivering shareholder value. Think of ROE as a handy tool for identifying industry leaders. A high ROE can signal unrecognised value potential, so long as you know where the ratio's numbers are coming from.

The table below highlights some of the most profitable companies in Australia based on the single metric of ROE. We've removed companies with excessive debt and low liquidity from the list, and have highlighted those that brokers seem to be keen on right now. 

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