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…Brokers and portfolio managers often speak in what seems like a foreign language. They
often 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.
The original article by Brandon Wendell has been edited here for length (…) and clarity ([ ]) by munKNEE.com – A Site For Sore Eyes & Inquisitive Minds – to provide a fast & easy read.
…The ROE can be useful when deciding which company in an industry is the better investment.
What is ROE?
…ROE is the amount of net income that the company makes in relationship to the shareholders’ equity [i.e. the percent profit a company makes for every dollar a shareholder has invested].
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…
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…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…
Other Considerations
You may not want to view ROE as a static figure. Many financial websites offer the current ROE as a key statistic when you look up their profile…[and such a] quick view will let you know how the company stacks up against others in the same industry…
The average of ROE over a period for a company, however, can likely tell you whether the company is continuing to grow and be profitable. Averaging the ROE over a longer period, such as five to ten years, for example, 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…
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