This week I want to talk about Return on Equity. Return on Equity, or ROE, is a commonly used measure of management efficiency. It’s a favorite screening criterion of many money managers and investors, including myself, because it tells you how successful a company is at using its shareholders’ capital. Moreover, companies with steadily increasing ROEs are generally better managed with attention being paid to the details.
Criteria Defined
Return on Equity shows how much profit a company is making on its shareholder equity. The formula for ROE is calculated as:
Income / Average Shareholders Equity (past 12 months). The Income number for a company is listed on their Income Statement. Shareholders Equity is the difference between Total Assets and Total Liabilities, and is found on a company’s Balance Sheet. ROE is always expressed as a percentage. So a company with a ROE of 10%, for example, means it created 10 cents of assets for every one dollar of shareholder equity in a given year.
How to Use
I think ROE is a great item to use regardless of what kind of investor you are – whether it be Growth & Income, Value or even Aggressive Growth or Momentum. Seeing how a company makes use of its equity, and the return it makes on it, is an important measure to look at. It can also alert you to problems when it’s falling. Another great way to use the ROE is to compare it to its Industry.
Some industries require greater assets than others to run their business. Take the Steel Industry versus the Software Industry for an extreme example. (Steel has a median ROE of 13.5%, while the Computer Software-Services has a median ROE of 7.5%.). If you screened for only absolute numbers, you may miss some great stocks in some great groups.
So trying to find companies with the best ROEs relative to their group (Sector or Industry etc.) is one of the best ways of making an apples-to-apples comparison in an effort to find the top stocks.
Conclusion
ROE can be a powerful screening criterion for investors in measuring how effective management has become, and how profitable they are in using investors’ cash. A better understanding of the factors that affect ROE, and how to best use it, will help make this criteria even more valuable to you.
The screen I’m running this week has me looking for companies with:
* ROE >= 5 Year Avg. ROE
* ROE >= Avg. for their Industry
* Zacks Rank = 1 (Strong Buys)
Here are 5 stocks from this week’s screen (for 10/20/09):
BUCY – Bucyrus International, Inc.
ISBC – Investors Bancorp, Inc.
STE – Steris Corp.
SVR – Syniverse Holdings, Inc.
WWW – Wolverine World Wide, Inc.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
Kevin Matras is the Research Wizard Product Manager and weekly contributing Editor at Zacks Investment Research who creates and writes the Zacks Commentary Screen of the Week and Know Your Options. For more information, visit http://www.zacks.com.
Article Source: Grading Management with Return on Equity
