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Key Fundamentals: Sales, Margins, Return On Equity

Return On Equity: How Efficient A Company Is With Its Money

ROE is one of the most popular ways to evaluate the financial performance of a growth company. ROE, sometimes called earnings power, indicates how well a company is being managed to allow a profit on its shareholder's money. It is also a reliable indicator of what a company can earn in the future. High ROEs, year after year, tend to reflect increasing profitability and superior management. Cyclical stocks, those that roughly move along with the economy, usually show more mediocre ROEs.

You should generally avoid companies with less than 17% return on equity. ROEs vary among industries, but this is the minimum you should find acceptable. And be sure to compare a company's ROE against others in the industry to get a realistic comparison. In most industries, the top-performing companies tend to have ROEs of 20% to 30%. Occasionally, companies will boast ROEs of 40% or even higher. The higher the percentage, the more efficient a company is in utilizing its capital.

The best stocks of the 1996-97 period had, on average, an ROE of 20%. For big-capitalization stocks, the average ROE was 29%.

ROEs have been increasing over the past several decades, largely because high technology has helped cut costs and boost productivity.

A Quick Way To Weigh Fundamentals

The Sales+Profit Margins+ROE (SMR) Rating -- part of the IBD SmartSelect® Corporate Ratings (A set of five key stock performance indicators.) -- saves you the arduous task of going over the financial reports of every company and helps you find the best companies in terms of financial performance. The rating looks at a company's sales growth over the last three quarters, its before- and after-tax margins and its return on equity. These four fundamental factors are widely used by analysts.

The SMR Rating ranges from A to E, with "A" being the best and representing the top 20% of all companies. The "B" stocks are in the next 20% and so on. The "E" stocks represent the bottom 20% and the lesser-quality companies. The rating also assigns a greater value to stocks in which any or all of these fundamental factors are accelerating. Look for stocks with ratings of "A" or "B."

Sales + Margins + ROE
(For Sample Purposes Only)

Daily Graphs®, a stock chart service that's a sister company of IBD, contains the SMR Rating (abbreviated "SMR Rate") and specific figures on sales and return on equity.

Cree Inc.

In IBD's stock tables, companies with top fundamentals are highlighted with a black bar. Stocks are selected weekly through a proprietary formula.

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