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%.
Every sector and industry will have varied average ROE’s, but when comparing companies within an industry, the company with the higher ROE may be the better investment.
Previously we saw that UAL had a ROE of 25.68%. American Airlines (AAL) has a ROE of 56.82%. Delta Airlines has a ROE of 37.80%. An investor would likely want to look deeper into American Airlines if investing in the major carriers as they seem to produce better income per shareholder equity. Update: On the day after I wrote this article, Delta Airlines beat earnings estimates and the stock price was up 3.64% before the market open. AAL, with its strong ROE, was up as well without news 2.20%, but with the weakest ROE ,UAL lagged, being up only 1.48%.
You may not want to view ROE as a static figure. The average of ROE over a period for a company can likely tell you whether the company is continuing to grow and be profitable. However, many financial websites offer the current ROE as a key statistic when you look up their profile. The quick view will let you know how the company stacks up against others in the same industry. As an investor, you want the companies you invest in to continue to perform well.
Averaging the ROE over a longer period, such as five to ten years, may give you a better picture of the company’s health. To get the average ROE, you will likely have to view the company’s annual financial reports and calculate the ROE for each year yourself. While this may take a little time and research, understanding one of the most popular investment evaluation ratios could be a great addition to your repertoire.
To learn more about this indicator and others, contact your local Online Trading Academy center today and enroll in a free workshop!