Fundamental Analysis and Position Trading: Evolution of a Trader

CHAPTER 10

Return on Shareholders' Equity

During my quest to discover why my officemate's random stock picks were beating my carefully chosen selections in 1979, I have to admit that I never considered looking at the return on shareholders' equity (ROE). Based on the results in this chapter, it would not have mattered much if I did. That may surprise you.

According to Value Line, return on shareholders' equity is “annual net profit divided by year-end shareholders' equity.” Another way of saying it is net profit divided by net worth. If profit rises faster than net worth, the thinking goes, then management is doing a better job running the business. Shareholders are getting a better return on their investment. The belief is that using ROE to compare other stocks in the same industry can help separate purebreds from mongrels. Unfortunately, you are still looking at dogs—stocks that might not perform up to expectations anyway.

• Return on shareholders equity is annual net profit divided by shareholders' equity.

Based on articles I have read, analysts look for 15 to 20 percent return on equity as the minimum for a quality investment. In fact, Ben McClure in his article, “Keep Your Eyes on the ROE,” makes a convincing case that ROE can act as a growth rate throttle. He writes, “. . . a firm that now has a 15 percent ROE cannot increase its earnings faster than 15 percent annually without borrowing funds or selling more shares. But raising funds comes at a cost: Servicing additional ...