Learn
fundamental analysis
Focus
on Return on Equity (ROE)
a stock analysis tutorial: use ROE
to pick the best stocks
Long-term
investors would fare better by focusing on a firm’s profitability
rather earnings per share when researching a stock.
Why? Because
as you’ll soon see, one profitability measure, return on equity, can
help you analyze a firm’s earnings growth prospects. But first some
background.
The headline
grabbing earnings per share figure, which is net income divided by the
number of shares outstanding, doesn’t tell you much by itself.
Suppose for
example that two companies both earned $1 million last year. However
company A did it on $10 million in sales compared to company B’s $100
million sales total. It’s clear that company A, with 10 percent return
on sales ($1 million divided by $10 million), is more profitable than
Company B with only a 1 percent return on sales.
Money
Managers Prefer ROE
While comparing income to sales is a valid measure, many professional
money managers prefer return on equity (ROE), which is net income
divided by “shareholder’s equity.” You’ll see why in a minute.
The shareholder’s equity figure comes from the balance sheet and is a
firm’s assets less its liabilities. The more familiar term, book
value, is simply shareholder’s equity expressed on a per-share basis.
Revisiting
the earlier example, suppose Company A and Company B’s shareholder
equities totaled $20 million and $10 million, respectively. Then,
Company A’s earnings translate to a 5 percent ROE ($1 million divided
by $20 million) compared to 10 percent for Company B.
ROE Limits
Growth Rate
It turns out that a company cannot grow earnings faster than its ROE
without raising additional cash. That is, a firm with a 15 percent ROE
cannot grow earnings faster than 15 percent annually without borrowing
funds or selling more shares. Of course firms often do raise funds by
selling shares or borrowing, but at a cost. Servicing additional debt
cuts net income, and selling more shares shrinks earnings per share by
increasing the shares out total.
So ROE is, in
effect, a speed limit on a firm’s growth rate, and that’s why money
managers rely on it to gauge growth potential. In fact, many specify 15
percent as their minimum acceptable ROE when evaluating investment
candidates.
Debt
Muddles
Using ROE in this manner does have one drawback. Recall that
shareholder’s equity is assets less liabilities. In this context,
liabilities mean all monies owed by the firm including its long- and
short-term debt. Suppose that two firms have the same assets. If so, the
firm with the highest liabilities has the lowest shareholder’s equity.
Since ROE is net income divided by the equity figure, the higher-debt
firm shows the highest return on equity.
Consequently,
you should take debt levels into account when comparing different
firm’s return on equities.
You can use
Yahoo’s profile report (quote.yahoo.com)
to check any firm’s ROE and debt levels (debt/equity ratios). Get
there by getting a price quote and then selecting Profile.
Concentrating
on truly profitable companies doesn’t assure success. Stocks move up
or down for any number of reasons, especially in the short-term. Further
research is required to determine if a company’s historical
profitability and growth trends are likely to continue into the future.
published 12/1/2002 |
