Within the Dow Jones Industrials (INDEX: ^DJI) , you'll find plenty of high-quality companies that do a great job of making money. But not all Dow stocks have shared that success, so you need to know which companies might have some dangers lurking beneath the surface.
One way to look at a company's ability to turn capital into cold, hard cash is to drill down on its return on equity. A close examination can tell you a lot about what makes a company tick.
Later in this article, I'll reveal the five Dow stocks with the worst returns on equity. But first, let's revisit the concept of return on equity to pinpoint what we're looking at.
The three key parts of ROE
Return on equity doesn't refer to your returns but rather the company's return on the shareholder equity on its balance sheet. By calculating earnings divided by shareholder equity, you'll get return on equity. But you can further break out return on equity into three separate components: net margin, asset turnover, and leverage.
Margin tells you how profitable a company is. Asset turnover, on the other hand, indicates how efficient a company is at moving its products or services. And leverage focuses on the division of the company's capital structure between debt and equity; companies that use debt effectively can greatly boost the returns for their equity investors. Seeing a breakdown of all three components tells you more precisely how a company earns money.
The Dow's worst ROEs
Let's turn to the five stocks from the Dow that have the lowest return on equity over the past 12 months:
Return on Equity
Bank of America (NYS: BAC)
AT&T (NYS: T)
Alcoa (NYS: AA)
Kraft Foods (NYS: KFT)
Source: S&P Capital IQ. All figures are for trailing 12 months.
*Adjusted to reflect continuing operations.
When you look at companies with high returns on equity, you find that different businesses have different attributes that help them boost ROE. Yet looking at these low-ROE companies shows much more commonality among all of them. None of these companies has particularly strong net margins, and while they all use leverage to a reasonable extent, their asset-turnover figures are uniformly subpar.
Bank of America stands out, although it's not entirely fair to apply return-on-equity figures to a bank because leverage plays such a huge role in determining bank profitability. But what B of A lacks that many of its bank peers have is a healthy profit margin, with so much capital producing so little income in recent years.
One-time impacts play a big part of some of the companies showing up at the bottom of the ROE ladder. AT&T also weighs in with poor ROE, although its figure took a big hit after its failed T-Mobile merger and the huge charge it had to take against earnings. Just a year ago, AT&T's return on equity was more than 18%. Once profit margins recover to their normal figures, AT&T shouldn't stay on this list for long. Similarly, Travelers had a terrible 2011 because of the many catastrophic events that hit during the year. Assuming more normal loss experience in 2012, the insurer should return to the double-digit ROEs that prevailed in past years.
For Alcoa and Kraft, however, low returns on equity could last for a while. Low aluminum prices don't appear to be breaking anytime soon, and until they do, Alcoa will have a hard time generating the profit margins it needs to boost its ROE. Similarly, the food retail business is notoriously low-margin, and stubbornly high commodity costs have pinched margins for some time. Eventually, relief from the commodity markets could help both of these stocks, but it's not a sure thing by any means.
What to do
Return on equity isn't the only thing you should focus on in your stock research. But as a starting point, it can provide a good guide on where to pay attention as you dig further.
Low-ROE stocks aren't likely to be your best bets. If you'd prefer some more promising ideas, let me invite you to look at some stocks that may give you a better starting point. The Motley Fool's latest special report reveals 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 Caplingerlikes looking at stocks with a critical eye. You can follow him onTwitter. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Bank of America. 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 policylooks at things the right way.