Brandon Wendell, CMT
Brandon Wendell
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%.
Other Considerations
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!
Neither Freedom Management Partners nor any of its personnel are registered broker-dealers or investment advisers. I will mention that I consider certain securities or positions to be good candidates for the types of strategies we are discussing or illustrating. Because I consider the securities or positions appropriate to the discussion or for illustration purposes does not mean that I am telling you to trade the strategies or securities. Keep in mind that we are not providing you with recommendations or personalized advice about your trading activities. The information we are providing is not tailored to any individual. Any mention of a particular security is not a recommendation to buy, sell, or hold that or any other security or a suggestion that it is suitable for any specific person. Keep in mind that all trading involves a risk of loss, and this will always be the situation, regardless of whether we are discussing strategies that are intended to limit risk. Also, Freedom Management Partners’ personnel are not subject to trading restrictions. I and others at Freedom Management Partners could have a position in a security or initiate a position in a security at any time.
Editors’ Picks
EUR/USD hits two-day highs near 1.1820
EUR/USD picks up pace and reaches two-day tops around 1.1820 at the end of the week. The pair’s move higher comes on the back of renewed weakness in the US Dollar amid growing talk that the Fed could deliver an interest rate cut as early as March. On the docket, the flash US Consumer Sentiment improves to 57.3 in February.
GBP/USD reclaims 1.3600 and above
GBP/USD reverses two straight days of losses, surpassing the key 1.3600 yardstick on Friday. Cable’s rebound comes as the Greenback slips away from two-week highs in response to some profit-taking mood and speculation of Fed rate cuts. In addition, hawkish comments from the BoE’s Pill are also collaborating with the quid’s improvement.
USD/JPY drops back below 157.00, as focus shifts to Japan snap election
USD/JPY is back in the red below 157.00 in the Asian session on Friday. The Japanese Yen recovers ground against the US Dollar amid some profit-taking ahead of Japan's snap general election on Sunday. The preliminary reading of the Michigan Consumer Sentiment Index report for February will be released later on Friday.
Editors’ Picks
EUR/USD: US Dollar to remain pressured until uncertainty fog dissipates Premium
The EUR/USD pair lost additional ground in the first week of February, settling at around 1.1820. The reversal lost momentum after the pair peaked at 1.2082 in January, its highest since mid-2021.
Gold: Volatility persists in commodity space Premium
After losing more than 8% to end the previous week, Gold (XAU/USD) remained under heavy selling pressure on Monday and dropped toward $4,400. Although XAU/USD staged a decisive rebound afterward, it failed to stabilize above $5,000.
GBP/USD: Pound Sterling tests key support ahead of a big week Premium
The Pound Sterling (GBP) changed course against the US Dollar (USD), with GBP/USD giving up nearly 200 pips in a dramatic correction.
Bitcoin: The worst may be behind us
Bitcoin (BTC) price recovers slightly, trading at $65,000 at the time of writing on Friday, after reaching a low of $60,000 during the early Asian trading session. The Crypto King remained under pressure so far this week, posting three consecutive weeks of losses exceeding 30%.
Three scenarios for Japanese Yen ahead of snap election Premium
The latest polls point to a dominant win for the ruling bloc at the upcoming Japanese snap election. The larger Sanae Takaichi’s mandate, the more investors fear faster implementation of tax cuts and spending plans.
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