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Investors watch and understand P/E ratio with a keep eye, using it to make trading decisions. And most know and understand market capitalization and other major financial metrics as a part of analyzing the fundamental health of a stock. However, many traders are not well versed in a very useful ratio for screening and comparing stocks in an industry: Return on Equity (ROE).
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| | | {loadposition contentad} | | | | | Return on equity at its most basic is a ratio of net income divided by net assets. It is sometimes averaged over time and referred to as Return on Average Equity. Either way, it's a very useful measure because it considers many other ratios as part of its calculation.
So simply stated, Return on Equity is Net Income divided by Shareholder Equity or Net Assets. This is useful because the ratio you end up with is an indication of how well the company turns its assets into income.
Here's a resource to better understand how ROE is calculated.
But here's the other key: it is only useful as you compare it to stocks within similar industries or the same sector. An ROE in one industry may be very good whereas the same score in another sector might be under-performing.
Now, using any one indicator alone as your only fundamental analysis isn't a good idea. So make sure the companies you are analyzing don't have any extenuating circumstances that are skewing ROE, like an acquisition or some kind of write-off. But when used properly, return on equity can provide a great tool for picking the cream of an industry group. Take stock brokerages as an example.
The Charles Schwab Corporation (SCHW) has one of the highest market caps in the industry at nearly $21 billion. It's return on average equity is 18.45%. But what does that mean? You really need to compare it with others in the industry to make the measure useful.
TD Ameritrade Holding Corp. (AMTD) has a slightly smaller market cap, but boasts an return on average equity of 22.20%. That means TD Ameritrade is a little better than Schwab at turning assets into profit. But the difference is small, and the ROE numbers for both indicate each is a very good stock fundamentally. Discount broker optionsXpress (OXPS) has a similar ROE.
E*TRADE Financial Corporate (ETFC), on the other has a negative ROE. In fact, the average return on equity is a startling -21%. Interactive Brokers Group, Inc. (IBKR) scores just under 10%.
Again, never use one single ratio as the sole factor in analyzing a stock. However, the return on average equity for stocks can give us an immediate look into which stocks in a particular group most effectively turn assets into profits and therefore stand out above peers.
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