Return on Equity Screen
|Return on Equity||S&P 500|
|Five Year Return:||14.6%||14.3%|
|Ten Year Return:||10%||5.8%|
Return on equity is a popular measure of profitably and corporate management excellence. The measure is determined by dividing the annual earnings of the firm by stockholders' equity. The measure relates earnings generated by a company to the investment that stockholders have made and retained within the firm. This latter figure—stockholders' equity is equal to total assets of the firm less all debt and liabilities of the firm. Also known as stockowners' equity, owners' equity, or even simply equity, it represents investor's ownership interest in the company. On the balance sheet it is the sum of preferred stock, common stock and retained earnings.
Return on equity indicates how much the stockholders earned for their investment in the company. $100 million in annual net income created on a $300 million stockholders' equity base is very good. ($100 / $300 = 0.30 or 30%) However, $100 million in annual net income relative to $3,000 million in shareholders' equity would be considered poor. ($100 / $3,000 = 0.03 or 3%) Generally, the higher the return on equity, the better. There are some notable exceptions that will be explored next week. A return on equity above 15% is good and figures above 20% are considered exceptional. It is important to compare return on equity with industry-wide averages to get a true feel for the significance of a company's ratio.
Return on equity is used as a criterion in a number of the screens posted on AAII.com. Michael Murphy, editor of the California Technology Stock Letter, looks for a minimum level of 15% for a company's return on equity as a measure of a firm's ability to finance its long-term capital requirements internally. Murphy feels that this test is particularly important for companies in capital-intensive industries, such as semiconductor production. Assuming no dividend payout, the return on equity equals the long-term sustainable growth rate. Faster growth has to be financed with additional debt or equity. Taking on debt has absolute limits and must be done carefully by companies in volatile industries. Issuing additional equity dilutes the ownership of existing shareholders, making their stock worthless on a per share basis. Murphy therefore prefers companies with a return on equity that can comfortably fund growth.
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