PRICE TO EARNINGS OR RETURN ON EQUITY?

When researching new stocks, a lot of people start with price to earnings valuation to help determine whether or not a stock is a good buy. While this is not necessarily a bad thing and hopefully not the only thing used to determine value, I've found that I come out better by starting with return on equity. While I also review long term debt, earnings per share and yes, price to earnings, I've found that stocks with a good record of ROE usually make good long term investments. I've read that Warren Buffett also considers return on equity as one of the primary considerations with his stock picks, so I think I'm in pretty good company on this one.

Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. It pays to invest in companies that generate profits more efficiently than their rivals. ROE can help investors distinguish between companies that are profit creators and those that are profit burners. Then again, ROE might not tell the whole story about a company, and therefore mus be used carefully. A steadily increasing ROE is a hint that management is giving shareholders more for their money, which is represented by shareholders' equity. Simply put, ROE indicates know how well management is employing the investors' capital invested in the company. Think of ROE as a handy tool for identifying industry leaders. High ROE's can signal unrecognized value potential, so long as you know where the ratio's numbers are coming from.