Question

You need to provide investment suggestions to your customer. There are two stocks under consideration and their data shows:

	ROE	Profit Margin	Total Asset Turnover Ratio	Equity Multiplier
Company A	35%	25%	1.12	1.25
Company B	35%	8%	1.15	3.8

Which company (if you can choose only one of the two) will you recommend to your customer based on the above data and why?

Please show work.

Answer 1

Return on Equity (ROE)=Profit margin*Total asset turnover ratio*Equity Multiplier

Both the companies have same ROE of 35%. But the company B's ROE is driven by higher Equity multiplier. high Equity multiplier is due to high debt financing in the company whcih is risky for the company in the long run.

To the contrary company's A ROE is driven by higher profit margin which is good and low equity multiplier. This means lower debt in the company.

Hence, I recommend Company A is better investment option.