Return on equity (sometimes abbreviated as ROE) can be a very useful financial metric to take into account when analyzing a stock. When used correctly, it can help investors better understand the financial health of the company. However, there are some important guidelines to keep in mind when using ROE for investing analysis, as will be explained below.
What Is Return On Equity?
Essentially, return on equity measures the profitability of a corporation. It tells you how “good” or “bad” a company is at making money (with a few caveats on this topic, as will be explained). The mathematical formula for calculating ROE reveals how much profit is generated for each dollar of total net worth (while subtracting debts), by taking the net income of a company and dividing that by something called “shareholder equity.” Shareholder equity is a term that measures the total net worth of a company in the imaginary scenario that all of its assets were suddenly sold off and outstanding debts were paid back.
While a stock’s return on equity ratio can be accessed from investing research platforms (including Chaikin Analytics), investors can also easily calculate it themselves using a company’s income statement and balance sheet, which all publicly traded companies are required to disclose. Here’s how: First, find the company’s net income on its income statement and divide that by “shareholder equity,” which itself is calculated by subtracting total liabilities from total assets. The final result is its return on equity.
Why Is Return On Equity Important?
When looking for Bullish stocks, how important is it that a company is able to generate profits? For many, particularly for investors who prioritize fundamentals, this is very important. Return on equity gives investors a sense of how good a company is at making money.
This metric is especially useful when comparing two stocks in the same industry. For example, if an investor was comparing two similar real estate stocks, some of their metrics may be industry-reflective. Digging into a metric like ROE could give you a clearer picture of which stock has the better balance sheet.
How To Use Return On Equity And A Few Notes Of Caution
Now that the “what” and “why” of return on equity have been explained, it’s important to make clear how this metric should be used by investors. For example, what is a “good” return on equity number, and what is a “bad” one? There is no clear-cut answer to this, but there are some important guidelines to keep in mind.
As a general rule of thumb, some investors like to use the S&P 500 as a benchmark. Since the S&P 500 averages returns of about 14% a year, this may be considered an acceptable shorthand for a good return on equity ratio. Anything less than 10% might be considered a poor return. In addition, although this may seem counterintuitive at first, extremely high return on equity is not necessarily a good thing. That’s because extremely high ROE can be a signal of a variety of underlying issues, including outstanding debt, or profit inconsistencies. Investors should always be sure to look at return on equity in conjunction with other metrics like debt and return on assets (ROA) for a complete picture of a company’s fiscal health.
It’s also important to keep in mind that “good” or “bad” return on equity for a company can be very dependent on the industry. Some industries are simply better at churning out bigger profits than others. Utilities, for example, tend to see low return on equity numbers, whereas technology stocks (such as the FAANGs) tend to see high ones. Therefore, comparing metrics within an industry can be quite useful, but comparing metrics across different industries could lead to false assumptions about how the company is performing.
Accessing ROE In Chaikin Analytics
How can Chaikin Analytics members access return on equity data when analyzing a stock? The Chaikin Analytics platform makes this easy. In fact, there are two ways to analyze return on equity: via the Chaikin Power Gauge stock rating factor, which offers a “done-for-you” overview on whether a stock’s return on equity should be considered Bullish or Bearish, and a more in-depth report of its ratio via the Power Gauge Report.
For an easy-to-read return on equity overview, simply expand a stock’s Chaikin Power Gauge stock rating from any stock chart in Chaikin Analytics, and then drill down on the Financials factor. Return on equity is the factor in the middle. Here, members can clearly see whether the factor is Bullish (green), Neutral (yellow), or Bearish (red)
For more in-depth analysis, Chaikin Analytics members can review the stock’s Power Gauge Report. Under the Financials component, members can view an exact return on equity figure, based on the company’s last quarterly earnings report.
While return on equity should certainly not be the only metric used when analyzing a stock, it can be an illuminating one, particularly for fundamentally-driven inventors, and for those comparing two or more stocks within the same industry.