The Dow Jones Industrials (INDEX: ^DJI) include some of the highest-quality companies in the world. But if you want to narrow down your investing options even further, you can take a closer look to figure out which companies are the absolute best at doing what all businesses should do: making money.
One of the simplest ways to evaluate how well a company invests your hard-earned money is to look at a measure called return on equity. It's easy to calculate, but when you get into the details, you can learn a lot about a company and how it functions as a money-making enterprise.
Later in this article, I'll reveal the five Dow stocks with the best returns on equity. But first, let's take a closer look at the measure and why it's important.
Understanding return on equity
The first thing you should know about return on equity is that it doesn't refer to your return as a shareholder. Although stocks are also called equities, the "equity" we're talking about here is the shareholder equity on the company's balance sheet.
Return on equity is simply defined as what a company earns in a year divided by the average shareholder equity for that year. If you forget the numbers for a minute, the concept should make sense: shareholder equity represents the equity capital invested in the business, and earnings show you the income the business generated with that capital.
But as we often do at the Fool, you can drill down even further on return on equity to separate it out into three components. They include the following:
Net margin, which tells how much of a company's sales end up as profit.
Asset turnover, which measures efficiency of a company's operations.
Leverage, which shows the extent to which a company relies on debt to enhance its profits.
By looking at each of these three components, you can get a better sense of exactly what drives profits at your favorite companies.
The Dow's top ROEs
So without further ado, let's take a look at the five stocks from the Dow that have the highest return on equity over the past 12 months:
Return on Equity
Boeing (NYS: BA)
IBM (NYS: IBM)
Caterpillar (NYS: CAT)
McDonald's (NYS: MCD)
Source: S&P Capital IQ. All figures are for trailing 12 months.
Notice the different ways that these companies milk profits out of their operations. Boeing's aerospace business is extremely capital-intensive, requiring huge investments of capital to produce the aircraft the company is famous for. Despite being in the bottom 10 among Dow stocks in net margin, the immense leverage that Boeing needs to operate produces the highest return on equity in the Dow by far.
By contrast, look at Microsoft and McDonald's. Both of these companies have very high profit margins, but they don't use leverage to boost their returns on equity. Microsoft in particular is well known for its extensive cash hoard, eschewing leverage but maintaining high margins, especially on its software products. McDonald's, on the other hand, is in the top five in asset turnover, and that combined with an impressive profit margin in the cutthroat fast-food industry gets it onto this list.
If you prefer companies to be more balanced in their approach toward earning profits, then IBM and Caterpillar will appeal to you. They use leverage fairly extensively, but not nearly to the extent that Boeing does, while taking advantage of respectable asset turnover rates and decent profit margins to put together impressive return on equity figures.
Different investors don't all agree on which of these factors are "good" or "bad" for a company. But stocks definitely aren't one-size-fits-all investments, and these metrics can help you differentiate stocks from each other and help you isolate the characteristics that you find attractive in a stock.
What to do
Return on equity isn't the only figure you should look at in picking a good stock. But it does tell you a lot about how a company makes its money, and it can reveal some warning signs you should watch to make sure a company doesn't lose its competitive edge.
Drilling deeper into your investments is important if you expect your portfolio to provide for you in your retirement. To get more information on how you can retire rich, please accept my invitation to read The Motley Fool's latest special report. Inside, you'll find some helpful advice, along with the names of three smart stocks for long-term investors. The report is free -- but don't wait: Read it today.
At the time thisarticle was published Fool contributorDan Caplingerloves when his investments make money. You can follow him onTwitter. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Microsoft and IBM.Motley Fool newsletter serviceshave recommended buying shares of McDonald's and Microsoft, as well as creating a bull call spread position in Microsoft. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Fool'sdisclosure policyis simply the best way.
Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.