Understanding Return on Equity

If you are thinking about investing in stocks directly, rather than buy into an index fund or mutual fund, then you are going to have to learn which fundamentals are the most important to look for when choosing a company.

If you ask most successful investors which is the most important factor they look at when choosing stocks then they’ll tell you that a good Return on Equity (ROE) is the number one fundamental they look at.

But what is Return on Equity, and why is it so important?

ROE is calculated by dividing the shareholders equity by the company’s earnings over the past twelve months. Here’s the simplified equation:

ROE: twelve months earnings / shareholder equity

Of course it’s rare that you need to calculate this yourself, because most companies prominently display its ROE on its financial sheet so it’s very easy to find. If you are looking online you can find this on their Key Statistics page.

Here is Exxon Mobil’s Return on Equity showing it as 23.43%.

Usually the better the ROE figure, the better the company’s management is doing balancing profitability, financial leverage and asset management. Or more simply – they are managing the money that they get from shareholders well.

Generally the higher the ROE the better the company is doing, but there are ways that companies can manipulate this figure so you will still need to look at the whole picture before you choose to invest into it.

My rules for investing in the stock market state that choosing a company that has a return on equity of at least 15% will help you to choose a good company. Although there are four other rules that I use to determine how to choose the best of the best stocks as well.

Currently out of the thirty companies listed within the Dow Jones (DJI), 20 of them have ROE’s over 15%.

Some of them, such as Boeing have really high ROE figures.

Does a high ROE correlate to an increasing stock price?

Generally yes it can, although you need to still look at other factors such as how much debt the company is carrying and what their earnings are. As you can see from Boeing’s chart, a high ROE figure has shown that the company stock price has increased over the past twelve months (even it if has been quite jumpy during that period).

I’m the author of 5 Simple Rules for Investing in the Stock Market – a quick guide about using five different fundamentals to choose the best stocks to invest for the long term.