Go With The ROE

IMAGINE THAT YOUR SAT score, annual salary and body-fat ratio were prominently tattooed on your forehead. That's how naked a company's managers must feel, given that their return-on-equity ratios are exposed for all to see.

ROE, a measure of efficiency, is simple to calculate and surprisingly telling. It's found by dividing a company's earnings by its shareholders' equity, or book value. The more earnings a company can produce with the same resources, the higher the ROE — and the more efficient the company is operating. Many managers, in fact, are paid according to how much they can boost ROE.

And that's where things get tricky.

There are three ways to pump up ROE, since the earnings-over-equity fraction is actually the product of three other fractions: earnings/revenues (profit margin), revenues/assets (asset turnover) and assets/equity (leverage). (To see for yourself, multiply them together. You'll find that the two "assets" cancel out, as do the two "revenues," leaving just earnings over equity.)

Managers looking to raise ROE can boost profit margins through effective advertising or cost-cutting, or they can increase asset turns by selling more stuff with the same equipment. Either of those outcomes would be great for investors. But managers can also boost ROE by increasing leverage. That's right: The more debt a company takes on, the higher its ROE will be.

So while ROE is indeed a powerful investing measure, it can also make heavy borrowers look unduly good. That's why, when looking for companies that generate profits efficiently, we like to use ROE in conjunction with return on invested capital, or ROIC. Where ROE subtracts debt from the bottom side of the equation, ROIC adds it on, making the overall ratio smaller for big borrowers.

We recently used our stock-screening tool to search through our 8,300-stock database for companies with high ROE and ROIC. We also looked for strong sales and earnings growth, moderate debt and healthy profit margins. For the details on all of our criteria, see the recipe on the top right of this page. Our requirements left us with a list of 10 ROE overachievers.

Mentor

Santa Barbara, Calif.-based Mentor (MNTR) makes penile-implants. Giggle if you must, but keep in mind there's an impressive market out there for such products — and profits to be made for investors. Take Mentor, which for its fiscal 2003 year ended March 31 posted a 33% earnings increase, to $55.8 million, and a 19% revenue increase, to $382.4 million. That makes for a profit margin of 14.6%, more than double the Standard & Poor's 500's 6.1%.

Mentor was founded in 1969, when four partners raised $50,000 in start-up capital and began developing urethral catheters. The company quickly became a major provider of such products, and in 1980 began to develop an implantable penile prosthesis. A 1984 acquisition of a breast-implant maker diversified Mentor's product catalog and more than doubled its sales.

In fiscal 2003, Mentor derived 50% of its revenues from its surgical-augmentation business, which includes cosmetic breast implants and post-mastectomy reconstructions, as well as liposuction and tissue-expanding products. (The latter uses a subcutaneous balloon to stretch skin, either to make room for an implant or to cover an adjacent scar.) About 28% of Mentor's sales were derived from the surgical urology division, which includes products for incontinence, inflatable implants for erectile dysfunction, and radioactive seeds used to treat prostate cancer, a process called brachytherapy. The remaining 22% of sales came from clinical and consumer products like catheters and bladder-cancer test kits.

A look at the stock's chart shows lackluster performance seemingly at odds with the company's strong earnings growth. Shares have backed off about $3 over the past three weeks, to $19 today. Analysts have expressed concern over competitor Inamed's (IMDC) lead in seeking regulatory approval of a new silicone breast implant.

Silicone implants overwhelmingly outsell saline models overseas, but have been banned in the U.S. because of concerns of increased cancer risks. A recent National Institutes of Health study, however, found no such increased risk, and it's widely believed that silicone will soon replace saline as the implant of choice in the U.S.

Trouble is, while Inamed filed for domestic approval of its silicone product at the end of 2002, Mentor won't complete its filing until the end of this year. That could dampen sales in Mentor's most lucrative division.

But there's reason to believe Mentor's stock is cheap nonetheless. The company has reduced breast-implant income as a percentage of sales to 45% from 60% two years ago, thanks to expansion, both internal and by small acquisitions, in its urology and consumer-product businesses. And analysts say the company is well-positioned to continue that trend.

To show why we think Mentor is a better deal than peers such as Inamed, we lined up the industry's four biggest players using our stock-comparison tool.

Note that Mentor's return on equity of more than 20% is by far the highest in the group, thanks to increased sales and rising margins. But the stock's price/earnings multiple is also the lowest of the four, at 14.7, compared with 22.4 for Inamed. And while Mentor's second-highest long-term earnings-growth projection of 18% annually slightly trails Inamed's 18.8%, dividing the P/E by the earnings-growth rate gives us a price/earnings-growth, or PEG, ratio of 0.82. That's not only the lowest of the bunch, including Inamed's 1.19, but is also well below the S&P 500's 1.54.

Fidelity National Financial

On April 1, Irvine, Calif.-based title insurer Fidelity National Financial (FNF) closed on its $1.05 billion purchase of Alltel Information Services, now Fidelity Information Services. The rationale for the deal: to add a new revenue source that's capable of offsetting any slowdown in the title insurance industry, where Fidelity now enjoys a 30% market share.

Last week, the company announced its goal of increasing revenue from $800 million in 2002 to $2 billion by 2005. It says it will post internal-growth rates of 10% to 15% and will continue to make strategic acquisitions. By that time, says management, title insurance will account for only 50% of sales, compared with nearly all of its sales last year.

Fidelity's 2003 P/E of 7.1 is well below the title-insurance industry's 11.0 or diversified financial companies' average of 13.0. And Fidelity is projected to increase earnings at 13% a year over the next five years, according to Reuters Research — more than twice title insurers' 5.7% and even a touch above diversified companies' 12.3%.

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