Course 205: Measuring Returns on Capital
ROE and Internet Stocks
In this course
1 Introduction
2 Return on Equity
3 Why Return on Equity Matters
4 ROE and Internet Stocks

As a concrete example, consider the fastest-growing segment of 1999, Internet stocks. Most Internet companies are growing at a torrid clip, but few of them are generating profits, and apart from America Online AOL and its 25% ROE in 1999, none have generated a high return on capital. In 1999, the return on equity for market darling Amazon.com AMZN was negative 270%. In other words, for each dollar shareholders had invested in the company, Amazon lost $2.70. To replenish the lost capital, the company must either issue debt or turn to shareholders for more money--and there are still plenty of people willing to pony up the money to own a piece of Amazon. If Amazon is going to justify its price, it will eventually have to generate good returns on capital, and whether it can do that depends on which pundits you listen to. But there's no argument that returns on capital are the engine that drives stock prices in the long run. Companies that go on to earn good returns on capital--ROEs of more than 15% or 20%--will probably make good investments. Those that struggle to earn a decent return will probably be wretched investments, regardless of how fast they grow. So if someone tries to talk you into investing $10,000 in a sci-fi restaurant or in a few hundred shares of an Internet stock, don't ask how fast the company will grow. Ask how the heck it's going to earn a good return on its capital.

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