The management of a company is crucial to its success. Before you buy stock in a company, you want to know that the company’s management is doing a great job. But how do you do that? If you call up a company and ask, it may not even return your phone call. 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). Here’s an example of an income statement.
| |
2015 Income Statement |
2016 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. Check out this balance sheet for Grobaby, Inc.
| |
Balance Sheet for December 31, 2015 |
Balance Sheet for December 31, 2016 |
| Total assets (TA) |
$55,000 |
$65,000 |
| Total liabilities (TL) |
–$20,000 |
–$25,000 |
| Equity (TA minus TL) |
$35,000 |
$40,000 |
Grobaby’s earnings went from $7,000 to $12,000. Above, you can see that Grobaby increased the equity from $35,000 to $40,000 in one year. The ROE for the year 2015 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 in 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 in the first table. The earnings grew from $7,000 (in 2015) to $12,000 (in 2016), 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, shoot for 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’s a good ide 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.
