Indian Ticker : Choose Right Stocks that Ticks Money

Secret #4: Calculate how well management is using the money they have

Home buyers understand about equity. It is the value of the home less the amount owed to the bank. The same is true of a business. Its equity is the total assets minus all the liabilities. You can think of this as the money locked up in the business. It is a measure of how much money management has to run the business.

Another measure of the money available to management is the capital of the business. This is its equity plus the long-term debt of the company. Clearly the success of any business is going to depend on how well management uses its equity and its capital. This is commonly measured by two ratios called return on equity and return on capital. Putting it simply, these are defined as the earnings of the company divided by equity and by capital. Their abbreviations are ROE and ROC.

Many companies consistently lose money year after year. So they do not even have an ROE or ROC. Others have very low values for these ratios. In other words, management is struggling to make a profitable use of what it has. Clearly, these are not the sort of companies that we should think of as quality investments. If management is only making a few percent on the money that it has, then over time this is all you can expect to make if you purchase shares in the company. After all, money can’t come from nowhere.

Every year, Warren Buffett writes in the annual report of Berkshire Hathaway that he is eager to hear about businesses that, amongst other things, are earning“good returns on equity while employing little or no debt.” This means that ROE and ROC are essentially the same.

It makes sense. If you want a healthy return on any shares that you purchase, at the very least you need to select companies with management that is making a healthy return on the money that they have.

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