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How to Evaluate Company Management for Potential Stock Investment

The management of a company is crucial to its success. Before you invest in a company’s stock, you want to know that the company’s management is doing a great job. How do you know whether management is running the company properly? The best way is to check the numbers. If the company’s management is running the business well, the ultimate result is a rising stock price.

Return on equity

Although you can measure how well management is doing in several ways, you can take a quick snapshot of a management team’s competence by checking the company’s return on equity (ROE). You calculate the ROE simply by dividing earnings by equity. The resulting percentage gives you a good idea whether the company is using its equity (or net assets) efficiently and profitably.

Basically, the higher the percentage, the better, but you can consider the ROE solid if the percentage is 10 percent or higher. Keep in mind that not all industries have identical ROEs.

To find out a company’s earnings, check out the company’s income statement. The income statement is a simple financial statement that expresses this equation: sales (or revenue) minus expenses equals net earnings (or net income or net profit). You can see an example of an income statement here:

2011 Income Statement 2012 Income Statement
Sales $82,000 $90,000
Expenses –$75,000 –$78,000
Net earnings $7,000 $12,000

To find out a company’s equity, check out that company’s balance sheet. The balance sheet is actually a simple financial statement that illustrates this equation: total assets minus total liabilities equals net equity. For public stock companies, the net assets are called shareholders’ equity or simply equity.

Balance Sheet for December 31, 2011 Balance Sheet for December 31, 2012
Total assets (TA) $55,000 $65,000
Total liabilities (TL) –$20,000 –$25,000
Equity (TA minus TL) $35,000 $40,000

You can see that Grobaby’s earnings went from $7,000 to $12,000. Grobaby increased the equity from $35,000 to $40,000 in one year. The ROE for the year 2011 is 20 percent ($7,000 in earnings divided by $35,000 in equity), which is a solid number. The following year, the ROE is 30 percent ($12,000 in earnings divided by $40,000 equity), another solid number.

A good minimum ROE is 10 percent, but 15 percent or more is preferred.

Equity and earnings growth

Two additional barometers of success are a company’s growth in earnings and growth of equity.

  • Look at the growth in earnings on the income statement above. The earnings grew from $7,000 (in 2011) to $12,000 (in 2012), a percentage increase of 71 percent ($12,000 minus $7,000 equals $5,000, and $5,000 divided by $7,000 is 71 percent), which is excellent.

    At a minimum, earnings growth should be equal to or better than the rate of inflation, but because that’s not always a reliable number, it is best at least 10 percent.

  • Grobaby’s equity grew by $5,000 (from $35,000 to $40,000), or 14.3 percent ($5,000 divided by $35,000), which is very good — management is doing good things here. It is ideal to see equity increasing by 10 percent or more.

Insider buying

Watching management as it manages the business is important, but another indicator of how well the company is doing is to see whether management is buying stock in the company as well. If a company is poised for growth, who knows better than management? And if management is buying up the company’s stock en masse, that’s a great indicator of the stock’s potential.

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