Comfort Zone Investing: One Thing All Great Stocks Have

Return on Equity: Return on equity is shown as a percentage. It can range from negative to positive, from minus 20% to plus 100% or more, in both directions. Most companies fall in the range between 5% and 25%. This measure shows you how well management is doing with the capital investors provide, the equity of the company. When you buy a stock, you're buying part of the equity.

In other words, if a company has equity of $100 and earns $10 in a year, the return on equity is 10% (10/100). You don't have to do the math. The ROE (return on equity) is provided by most quote programs on AOL, MarketWatch, Yahoo!Finance, etc. You can immediately see that the higher this number is, the better your return is. This does not always translate into an equal upward movement in the stock, however.

That's because stock prices usually anticipate earnings. If there's a negative surprise (let's say the above company was supposed to have an ROE of 15% and came in at 10%), then investors would most likely sell this stock or at least not buy any more. However, so many factors play into a stock's price (revenues, margins, outlook, etc.) that no one number will make it go up or down.

What ROE does for the investor is show how well management has done with capital over time. When you look at ROE over a decade, and it increased every year, then you've got a company that warrants your attention. It means management is using capital wisely, year after year.

Any stock with increasing ROE will eventually go up. In fact, it may go up too much. That's because investors get a little over excited sometimes (not that you do). A strong ROE, especially ever increasing, makes investors' adrenaline pump.

Return on Assets (ROA): Another way to measure management is the ROA. It's the return a company is making on the assets it buys, such as drilling equipment, chairs, desks, computers, trucks, people, etc. All the stuff that makes a business a business. It's reported as a percentage. The calculation: net income/total assets equals ROA.

ROA numbers vary from industry to industry. For example, in the financial industry, an ROA of 1% is the benchmark. When management earns well above that, it's doing something better than competitors. When using ROA, it only makes sense to compare the stock in which you have interest to others in its industry.

ROA uses both the debt and equity as sources of funding for assets. The ROA shows investors how well management is converting the money at its disposal (equity and debt) into net income. You want high numbers. When you compare two companies (in the same industry), if one has a 10% ROA and the other a 5% ROA, the first one is using funds more effectively, and investors are getting a better return on assets.

ROA is kind of a brain test for management. The smarter the management team, the better they use money.

There is one more test every investor would like management to take but can't be given. It's the honesty test. They haven't come up with that one yet. But usually good management stays out of the headlines and focuses on the business at hand. It doesn't have a high profile or any negative news in the past. Most managers fit this profile. But there are some notable exceptions (names like Bernie Ebbers, Ken Lay, and Dennis Kozlowski come immediately to mind). There was no way investors could decipher how poorly these companies were run until it was too late. And that's one of the risks that never goes away for investors.

Always check the ROE and the ROA of a company. Then compare those numbers to the industry's. The best management has the highest in both categories. And so do the best stocks.

Ted Allrich is the founder of The Online Investor, chairman of the board of Bank of Internet USA, as well as the author of the book Comfort Zone Investing: Build Wealth and Sleep Well at Night. In this weekly column, he offers advice to investors who are just getting started.