When most people are screening for investment ideas, they naturally gravitate to metrics like the price to earnings ratio, the price to book ratio, debt levels and net income. Those are all important metrics to analyze and consider. Indeed, many investments can be dismissed if a couple of these metrics don't pass the test of value. Yet, one number that should paid attention to more often is return on equity, specifically return on unlevered equity.

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A Basic Primer
Return on equity is simply net income divided into shareholders equity. A high return on equity implies that a company is generating relatively high profits in relation to the company's invested capital. A company with $100 in income against $1,000 in shareholder equity has an ROE of 10%. A company can earn $200 against $1,000 in equity has a ROE of 20%, a much more desirable business. However, there is one major caveat. In good times, a company can boost its earnings or reduce its equity capital buy choosing to take on debt. In this regard, leverage helps boost ROE. In the rare instances where leverage makes sense, this can be fine. However, when ROE is inflated because of leverage, ROE is not as desirable as it seems. Pay attention to debt levels when examining ROE. (For more, see Return On Equity - Investopedia Video.)

Value Creation
With the above primer in mind, a consistently above-average ROE is something to be examined closely. A company with a 10-year ROE of 20% means that for every dollar that the company can invest in the business, it is earning $1.20. If a company can then take that $1.20 and invest again at a 20% ROE and continue this for years, you may have something special. Microsoft (Nasdaq:MSFT) used to be one such company. For over 20 years, Microsoft has 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. Today, the company still generates ROE of over 40%, but only on the capital it invests in the business. Microsoft is still cheap today, but don't expect the type of returns of the 1980s or 1990s.

Hansen Natural Corp (Nasdaq:HANS) is a seller of all natural beverages. The company virtually has no debt, and has an average ROE of over 20% in the past 10 years. Shares aren't a bargain at $57, but it's worth keeping an eye on. Paychex (Nasdaq:PAYX) provides payroll and accounting services to small and medium businesses. Annual return on equity has been nearly 30% for the past 10 years, and the company is debt free. Rockwell Collins (NYSE:COL) is manufacturer of aviation electronic and communication systems. The balance sheet is conservatively financed with a debt to equity ratio of 25%. Return on equity has averaged between 21% and 48% over the past decade.

The Bottom Line
A company with a consistent above-average return on unlevered equity is clearly doing something right. Such a company may not ultimately pass the test of value, but in the long run, a high return on unlevered ROE is usually followed by a growing stock price. (For more, see How Return On Equity Can Help You Find Profitable Stocks.)

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