Return on Equity (ROE) 101 for Stock Analysis
What It Does
ROE quantifies, judges, the quality of a company's management team. It measures how efficiently management uses the company's net assets or net worth to grow the company and to create new assets. In other words, ROE measures how efficiently management uses what the company owns to further grow the company.
Note:
1. Net worth is the value of everything the company owns minus everything it owes.
2. Net worth equals company assets minus company liabilities.
3. Net worth consists of reinvested cash, inventories, stocks and bonds, factories, machinery, real estate, natural resources, patents, trademarks.
What It Is
ROE is a percentage figure that results from dividing Net Income by Common Equity. The calculation is: Net Income/Common Equity=Return on Equity
Note:
1. You can find the figure for Net Income on the company's Income Statement and the Common Equity figure on the company's Balance Sheet.
2. In the term, Return on Equity, Return is the percentage the company earns by using its Common Equity
3. Other names for equity are net worth, net assets, common equity, stockholders' equity, and shareholders' equity. These terms are used interchangeably.
4. Equity, by any above name, is the capital that shareholders originally invested in the company plus the new assets that have been generated by the business since its beginnings. As shareholders we own a portion of all those assets---stores, buildings, machinery, real estate, etc. Granted, the portion our 100 shares represent is very small.
ROE tells how many cents of profit is produced per each dollar of net assets. An ROE of 15 percent means that management is able to produce 15 cents of new equity (net assets) for each dollar of equity the company presently owns.
If a company has an ROE of 9 percent, that company is able to produce only $0.09 of new net assets from the company's present net worth.
Which of the above management teams is the better one? Which management team is more efficient at producing new assets from each dollar of company equity? Answer: The one with the higher ROE.
ROE Is Also Called:
· Percent Return on Equity
· Percent Earned on Net Worth
· Net Income-to-Net Worth
· Return on Stockholders' Equity
· Return on Shareholders' Equity
ROE General Stock Analysis Points to Consider
First, a satisfactory ROE is between 13 and 15 percent.
· 10 percent is inadequate
· 20 to 25 percent is outstanding
· 30 percent is exceptional
Second, look for a company that has had an ROE of 15 percent or higher for the past 5 years.
Third, look for a company whose 5-year average and its current ROE are above the industry average. A company's ability to sustain a high ROE for several years indicates the company has a competitive advantage in its industry. It is the leader in its industry. It has name recognition. It controls a major part of its market. These conditions make it difficult for other businesses to successfully enter its market.
A more precise comparison is the company's ROE with those of its closest competitors. If a company's ROE is above those of its competitors, it means the company is probably taking market share from them.
Fourth, if a company has a high ROE, the time will come when the company is no longer able to increase its ROE. A high ROE is difficult to simply maintain. A company with an exceptionally high ROE may be a young company. Its ROE will decline to more normal levels over time as strong competition enters its market.
Four Specific Points for Company Analysis
1. An ROE of 15 percent or greater
2. An ROE that increased the most recent year or decreased only slightly (less than a 0.75 percentage point)
3. An ROE greater than the industry average or greater than the ROEs of its closest competitors.
4. A company that has less than 50 percent long-term debt-to-equity. (Companies can obtain a high ROE by simply borrowing a significant amount of money.)
ROE 201: What Impacts ROE (more to come)
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