Of the many ways to measure corporate performance and profitability, return on equity is a primary tool. Investors usually value a company with a high ROE above all others.

Even fast-growing companies need high ROE to generate the cash they need to finance continued growth. Indeed, a high ROE, it is argued, is a solid guarantee of corporate growth.

However, the matter of what is “high” is relative. The table (near right) lists 35 companies (out of 112 large-cap and mid-cap Canadian stocks) with average ROE of 15% or higher.

Why the 15% break point? Over the years, average ROE of North American companies appear to range between 10% and 15%. So these 35 are certainly above-average companies by this standard.

Why average the measurement? Because a multi-year average gives a more certain answer than the result of a single year. Consistency is what you want in corporate performance, not one-year wonders.

The average used here covers the three latest fiscal years. We chose the three-year measure because the acknowledged founder of investment analysis, Benjamin Graham, favoured this average for quantifying data.

ROE and its cousin, return on invested capital, measure how efficiently a company
uses the capital provided by investors and profits reinvested in the business. A company earning only 4% or 5% on its investors’ capital is scarcely efficient, when you can garner similar returns from a risk-free or low-risk investment in the money or bond markets.

Ultra-high ROE, however, may also be a burden. How do you better a remarkable record? That has been the problem faced in the recent past by, for example, money- and fund-management companies. It is the current challenge for CI Fund Management Inc. , the most profitable company in our survey.

If the list is heavily laden with energy-sector companies, this is a reflection of the times.
That sector is where sales growth and profit growth have been concentrated. It is a sign of recent conditions to find only three banks among the top 35.

If a company you are researching lacks a high average ROE, another favourable quality to look for is regular improvement in profitability. We find 30 such stocks in the 112 surveyed, showing step-by-step improvement from fiscal 2002 to fiscal 2004 (top table, far right). Some names also appear in the highest average ROE list. Energy stocks are well represented.

A third positive attribute is a steady ROE. You find this typically in utility and pipeline companies, or used to. Nowadays retailers are prominent, as the accompanying list (bottom, far right) reveals.

The 15 stable companies shown have the lowest relative standard deviation of their annual ROE over the latest three fiscal years. They are ranked in order, with Loblaw’s ROE having the least variation from year to year.

ROE is basic because it also provides a method for estimating profit growth. A company with an average ROE of, say, 18% is likely to produce a similar return in the future. You apply the ROE figure to latest shareholders’ equity and — presto! — you have an earnings estimate that is as valid as any.

Another approach to estimating future earnings from ROE is to note the high and low annual ROE over a longer period — say, five years or seven years. This enables you to gauge high and low probabilities of future earnings.

ROE, as with any tool of investment analysis, can be manipulated or influenced — to be specific, corporate capital structure can do this. A company with a large debt load relative to equity will produce a high ROE in a good year; in a poor year, a low ROE. In other words, large debt creates leverage, and this is one way it shows. That, if anything, is the flaw in ROE comparisons.

There are two commonly used ways to calculate ROE. The method used here is net income as a percentage of equity at the beginning of each year. The alternative is return on average equity for the year. The two calculations are equally useful. The equity used in this analysis is common equity — preferred capital (if any) has been stripped from each company’s data. Earnings figures are also net income for common
shares. IE