Equity is nothing more than all the assets of a company minus the total amount that the company owes. If the company makes a profit, that amount is matched against the equity to arrive at a return on equity. Generally, the higher the return on equity, the greater the amount is earned by the owners, or shareholders. Also, if a company has a high return on equity, it can generate most of its operating cash internally. To most people, it is a reflection of how successful a company is in generating a profit, and it is the most important ratio one must analyze before making an investment.
Instructions
1. Look at a company's ROE to determine how well a company is operating. Companies that do a good job with the assets they have at their disposal are generally good investments because they are adept at providing superior returns to its investors.
2. Be of the prowl for investment opportunities that have superior ROEs for at least five years. Such a pattern indicates that a company's management is adept at making a better-than-average profit over the long haul and that it considers the interests of its shareholders more than their own. For example, compare the ROE of Dell Computer with that of Hewlett Packard. While Dell created an unbelievable ROE of 46 percent, Hewlett Packard's was a meager 12 percent.
3. Interpret ROE correctly.Not all companies can be strictly analyzed for their strong ROEs. Let's say you are looking into one that has great potential but is currently operating at a loss. It might have been created on the strength of break-through technology and it is years away from turning a profit. In that case, an analysis of its ROE is meaningless. Instead, you will need to analyze the strength of the technology upon which it is relying to identify potential. For instance, eBay and Google went years before making a profit, but you would have made a fortune if you had been an early investor.
4. Understand that any analysis of ROE will be misleading if a company is leasing much of its equipment rather than buying it with retained earnings or borrowings. Since the company's equity will not be diminished by those leases, any ROE it shows will be inflated.
5. Realize that there is no system that provides a perfect way to analyze a company's fundamentals. But contrasting the five-year average ROEs within a specific industrial sector does highlight companies with competitive advantage and with a knack for delivering shareholder value.
