The Best Returns on Equity

A company's return on equity (ROE) can be a great help when you want to zero in on attractive companies -- as long as you're smart about how you use it.

ROE reflects how effectively a company is generating profits from its shareholder investments. To calculate it, divide net income by shareholder equity. Alas, this process reveals a shortcoming: It can yield a steep, appealing number if a company has a lot of debt. That's because shareholder equity equals assets less liabilities, and hefty debt will leave a small shareholder equity sum.

Failing to factor out high debt can yield misleading results. I screened for companies with:

• A market cap of $1 billion or more (to focus on less obscure companies)
• P/E ratios between 1 and 20 (to focus on more undervalued companies)
• Average ROE over five years of more than 16% (to avoid one-year wonders)

Among the top 10 resulting companies, six had total debt-to-equity ratios of more than 100%, meaning that they owed more (sometimes much more) than their total assets. That can be okay, provided a company reliably generates cash and can manage its debt. But in general, it's a red flag.

The winners are…
Rerunning that screen above with one additional criterion -- total debt-to-equity of 25% or less -- provides a more promising batch of candidates. After all, companies with little debt aren't constrained by repayment obligations. Here are the 10 resulting stocks with the highest ROEs:

Source: Google Finance.

Once you have a pool of companies to study further, you can start looking at other measures. One of the companies above, Apollo Group, sports just two stars (out of five) in our CAPS community of investors. For-profit online schools have been under fire lately, consumed by concerns about student loans, accreditation, and the value they deliver to students.

Three of the companies my screen found, including consulting and outsourcing business Accenture and wireless technology company InterDigital, sport four stars, reflecting considerable investor bullishness. A closer peek at InterDigital reveals a whopping net margin rate above 30%, which contributes to its high ROE. The high-margin nature of consulting bodes similarly well for Accenture. Industrial players GrafTech and McDermott each sport five stars, with investors bullish on their prospects as the global economy recovers.

If you favor dividends (and who doesn't?), the list above could encourage you to look more closely at BBVA Banco Frances and Terra Nitrogen. Both have high dividend yields.

Trends and peers
It's also important to consider trends. Aeropostale's ROE is near its all-time highs, and well above levels from earlier this decade. McDermott has seen its ROE come down significantly in recent years, while Apollo's has fallen just recently. GT Solar's ROE is harder to draw conclusions about quickly, as it has risen and fallen sharply in recent years. An ideal ROE to spot is one that's higher than average, and also rising steadily. That suggests that management is continually making the company more efficient.

Finally, look at competitors. Apollo's ROE may have fallen recently, but it's still higher than most of its peers in the for-profit education industry.

Screens like these can help you zero in on companies with characteristics you like. Bargains in the market abound -- you just have to find them.

Even some well-known fast-growers are on sale these days. Add the ones that interest you to our new feature, My Watchlist.