Why having a high ROE helps shareholders of Newmont
Return on equity (ROE) measures how efficiently a company uses Shareholders’ Equity to generate profits. For any readers unfamiliar with ROE, it is calculated by dividing net income by book value of equity.
It’s no coincidence that Warren Buffett is a fan of the measure - companies with high ROEs tend to exhibit the high-quality, moat-like business traits that he is so fond of gaining exposure to.
Under Buffet's investing philosophy, if you can find a company that consistently allocates its capital profitably (indicated by a high ROE), the chances are you are onto a long-term winner.
Unfortunately, CEOs at firms are not generally promoted based on their ability to allocate capital – even though this is what they then go on to spend time doing.
As Mauboussin writes in one of his research papers:
“Capital allocation is one of management’s prime responsibilities. Yet few senior executives are versed or trained in methods to allocate capital most effectively. Further, incentive programs frequently encourage behaviors that are not in the best interests of long-term shareholders.”
So, if as an investor you’re only looking at sales and earnings growth, you are missing an important question: how is that growth being funded?
Finding companies that allocate capital well
As investors, we want to find high ROE stocks whose fantastic business models are being rewarded by the market. One way to do this might be to screen for shares with both positive one-year relative strength and upgraded current year broker forecasts. The former ensures these shares have been outperforming the market, and the latter suggests the outperformance can continue.
One stock that currently qualifies for this screen is Newmont (NYQ:NEM). The group has:
- A trailing twelve month return on equity of 22.3%
- An average current year EPS forecast upgrade of 9.30% from brokers, and
- A one-year relative strength of 104.9%
What does this mean for potential investors?
Some of the best quality stocks in the market have defensible models that can deliver high levels of shareholder returns over the long term. But there are no guarantees and it's important to do your own research. Indeed, we've identified some areas of concern with Newmont that you can find out about here.
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