While it’s never a good idea to depend on one metric to decide on your investments, watching this key metric could help you beat the stock market. So, you should certainly add this metric to your process if you haven’t already.
Warren Buffett is one of of the best investors to learn from. He is a value investor who cares about how well a business makes money. Surely, a company is bound to be worth more over time if it’s able to consistently increase its earnings. Here’s how to invest like Warren Buffett. One key metric that Buffett looks at is the return on equity (ROE), which is a measure of a company’s profitability and how efficiently it generates profits.
The ROE is calculated as follows:
ROE = (Net income ÷ Shareholders’ equity) x 100
Investopedia explains that “because shareholders’ equity is equal to a company’s assets minus its debt, ROE is considered the return on net assets.” You would want to dig deeper into companies that have a high ROE. It’s a good sign if a company is able to consistently achieve an ROE of at least 15%. It would also make sense to compare a company’s ROE against those of its peers. Furthermore, you would want to observe a company’s ROE over at least the last five years instead of looking at it for one year.
An example of a solid stock with a high return on equity
A top TSX stock with a high return on equity that investors can explore is Constellation Software (TSX:CSU). According to Morningstar, its five-year ROE is just under 44%, which is superb. Sure enough, the tech stock has tripled investors’ money in the period, which greatly outperformed the market.
Further investigation shows a company that has consistently increased its earnings at an incredible clip. For example, the tech company’s 10-year adjusted earnings-per-share growth rate is approximately 23% per year.
Apparently, Constellation Software provides mission-critical software solutions that address the specific needs of its customers in particular markets. Its strategy to acquire, manage, and build vertical market software businesses has served it well by making durable and growing cash flows and revenues.
The company also has a solid balance sheet with a reasonable long-term debt-to-capital ratio of about 39%. It is currently awarded an investment grade S&P credit rating of BBB.
Is the tech stock too expensive at $3,625 a share?
One thing that might deter investors from buying the stock today is that it trades at a high price-to-earnings ratio of roughly 41, which investors could find to be expensive. Other investors would argue that the business’s high earnings growth potential make it reasonably valued.
We all know what Warren Buffett would say: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Constellation Software most definitely fits in the category of wonderful companies.
Not everyone can come up with $3,625. Not to worry, though. Interested investors could opt to average into the great stock via commission-free trading platforms like Wealthsimple, which also provides the option to buy partial shares. So, essentially, you can invest as little or as much as you want according to your schedule, whether you’re buying bi-weekly or monthly, for example.
