Investors are always looking for a better way to evaluate the stocks they are selecting for their portfolio. Brokers and portfolio managers often speak in what seems like a foreign language. Or they use abbreviations to make the investment process seem more complicated than it truly is. This week, we will examine one of these abbreviations, Return on Equity, (ROE) that is used to evaluate the potential returns of a company’s stock.
While I will time my entries and exits based on technical analysis, the selection process can be made easier if you utilize some fundamental analysis. The ROE can be useful when deciding which company in an industry is the better investment.
What is ROE?
While there are a couple of variations on the method used to calculate it, ROE is the amount of net income that the company makes in relationship to the shareholders’ equity. Shareholders’ equity is the total assets of the company minus the liabilities and is only considering common stock, not preferred shares. This equity can be either a positive number if the company has more than enough value in their assets to cover its liabilities, or a negative number if their debt is too high. We would be wise to invest only in companies that have positive shareholders’ equity since, if the company’s debt is too high they run the risk of default and bankruptcy.
As an example, the ROE for United Airlines (UAL) is 25.68%. This suggests that UAL generated a 25.68% profit for every dollar a shareholder invested.
So, the simple formula for ROE would be:
Return on Equity = Net Income/Shareholders’ Equity
What Should We Look For with ROE?
As investors, we are looking for the best returns, so with ROE, typically, the higher the better. A high ROE indicates that the company is capable of generating income through its internal operations. There was a study published by NYU that stated that out of approximately 7300 stocks, the average total market ROE was 13.63%.
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