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Tuesday, May 11, 2010

Measuring Management Effectiveness before Buying a Stock

One way to evaluate a stock is to look at how effective the company’s management is in utilizing the resources available to them.

This measure of management effectiveness provides you with an idea of how well the company is being run relative to others in its sector and the market as a whole. Consistently low numbers are a red flag.

Unlike many comparisons, you can use these ratios to compare companies in different industries. The ratio's are:
  • Return on assets 
  • Return on investment 
  • Return on equity 
Fortunately, you don’t have to compute these ratios yourself. Many websites provide this information.

Return on Assets

Return on assets tells you how well a company’s management uses its assets to make a profit.

You calculate the ROA by taking the net income and dividing it by the total assets. The ROA comparison works better over time so you can see a trend in how well management uses assets to the advantage of the company.

The higher the ratio, the better and the continued high level over time is even better because it indicates management makes a habit of managing with efficiency.

Poorly managed companies, will consistently fall before industry averages in this area, while better run companies stay out in front of the averages.
Return on Investment
Return on investment measures not only the company’s contribution, but also the purposeful use of leverage or debt to extend company’s reach.

You calculate ROI by dividing net profits by long-term debt plus other long-term liabilities plus equity.

Managers choose to combine the company’s equity with outside debt to extend programs quickly and efficiently.

Skillful use of debt can change a 50 million project into a 75 million project. If everyone has done their homework correctly, the company can see additional profit from a larger project than they could have afforded without the debt.

Return on Equity

If numbers are good, return on equity is like a music for stockholders ears. It measures how well management did in earning money for them.

Unlike return on assets and return on investment, this measure goes directly to the stockholders and their stake in the company.

Unfortunately, ROE is somewhat flawed. You calculate ROE by taking net income and dividing by shareholders equity. Missing from this equation is debt and that distorts the picture somewhat.

Although ROE is somewhat helpful in looking at companies, it doesn’t provide the guidance the ROA does.

Remember, look at the whole picture and not just a few numbers. Return on investment and return on assets are helpful in spotting quality management. Return on equity is less so, but still worth a look.