Return on equity (ROE) is an indicator calculated by dividing net income by shareholder's equity (company's assets minus its debt). ROE (also called return on net assets) can show how effectively a company uses its assets to generate profits.
How can I use ROE when I invest in stocks?
- You use ROE to understand the company's ability to generate profits using the number of net assets earned that the company possesses. A higher ROE is generally viewed as a more favourable investment option as it can create more income from every unit of equity. For example, Coca Cola has an ROE of 41% and shareholder's equity of $86 million, while Nike has an ROE of 29% and shareholder's equity of $8 million. This means that Coca Cola can generate $35.23 million of profit, while Nike only can generate $2.35 million of profit. This higher profit reflects a higher expected stock price and dividend payment, if the company issues dividends, thus, making Coca Cola the more attractive investment.
- The next question that you might contemplate is how high or low would a company's ROE be considered good or bad? This depends on how the company compares with the industry. For example, a software company would have a smaller balance sheet compared to an energy company. In this case, what matters is what the "benchmark" ROE is for each industry.
- As a general rule, you can consider a return on equity near the long-term average of the S&P 500 (14%) as an acceptable ratio and anything less than 10% as inferior.
Debt to Equity Ratio
Used to evaluate a company's financial leverage and is calculated by dividing a company's total liabilities by its shareholder equity.
Profit is the financial benefit realized when revenue from a business is higher than the costs and taxes involved in operating that business.
Alternative investment class composed of funds that invest directly in private companies or that buy public companies and take them private
Time of declining economic activity, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and sales.
A stimulus package is a coordinated effort by the government to increase spending and investment to "stimulate" an economy out of a downturn.
Shorting a stock
Trading strategy that tries to take advantage of the decline in a stock price by borrowing a stock and sell it now while planning to repurchase it later for a lower price.
Market-capitalization-weighted index tracking the performance of the 500 largest U.S. companies