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Return on Equity: What it is & Why it Matters for Growth Stocks

Nick Schmidt
Nick Schmidt

Nick Schmidt is a co-founder of TraderLion and Deepvue with over 10 years of market experience. Adopting a “less is more” philosophy, he focuses on weekly charts with an emphasis on price and volume.

November 25, 2023
6 min read
131 views

What is Return on Equity (ROE)?

Return on Equity (ROE) is a key measure of how effectively a company uses its shareholders’ money to generate profits. It shows how much profit a company makes for every dollar of equity financing. To calculate ROE, you divide the company’s net income by its shareholders’ equity and express the result as a percentage. This metric helps see how well a company is using its equity to make money.

A positive ROE suggests that the company is good at generating returns for its shareholders. To get a better sense of a company’s performance, it’s helpful to compare its ROE with others in the same industry.

How is Return on Equity Calculated?

Return on Equity (ROE) Calculation Formula

The formula for ROE is simple. Here’s how you calculate it:

  1. Find the net income on the company’s income statement.
  2. Look up shareholders’ equity on the balance sheet.
  3. Divide net income by shareholders’ equity.
  4. Multiply by 100 to get the percentage.

Pro Tip: ROE can give you insights into a company’s profitability and efficiency. But for a fair comparison, check the ROE of companies within the same industry. Another helpful metric to consider is Operating Income, which digs deeper into the company’s financial health.

The Role of Return on Equity in CAN SLIM:

William O’Neil uses return on equity (ROE) as a key metric for assessing how well a company turns its resources into profits. Within the CAN SLIM framework, ROE directly supports the “A” in CAN SLIM, which stands for Annual Earnings Increases. O’Neil highlights ROE as a way to gauge management’s effectiveness, helping investors identify companies that deliver strong returns on investment from those that fall short.

In How to Make Money in Stocks, O’Neil’s research found that many of the top growth stocks have ROEs of at least 17%. The best-performing stocks often hit 25% or more, sometimes even reaching 50% during their peak growth phases. This high ROE aligns with CAN SLIM’s focus on annual earnings increases—companies with strong ROEs usually show steady profitability, which tends to drive their stock performance.

For investors, a high ROE can indicate that the company is:

  • Efficiently Using Capital: A high ROE shows the company generates solid profits without needing a lot of additional capital.
  • Profitable Over the Long Term: Companies with consistently high ROEs tend to maintain competitive advantages, suggesting strong potential for continued earnings growth.
  • Effectively Managed: High ROE signals that management is effectively using shareholders’ funds, boosting investor confidence in the company’s future.

ROE Checklist

Investors using the CAN SLIM method, and focusing on ROE specifically, can more easily spot stocks with high growth potential and efficient operations. ROE acts as a quality check on a company’s annual earnings growth and overall profitability, supporting the CAN SLIM approach’s ability to uncover top-performing stocks. In short, ROE isn’t just a number—it’s a window into a company’s financial health and operational efficiency.

Here are some ROE guidelines inspired by O’Neil’s CAN SLIM strategy for identifying the strongest stocks:

  • Seek High ROE Companies: Look for companies with an ROE of at least 17%. The best prospects often show ROEs between 25% and 50%.
  • Compare Within Industries: ROE can vary a lot between industries. Comparing a company’s ROE to its industry average gives you a clearer picture of its relative performance.
  • Consistency is Key: Look for companies that maintain high ROE over multiple years. This consistency indicates stable management and reliable profitability.

What Factors Can Affect Return on Equity?

Several factors can influence a company’s ROE, such as profitability, debt levels, and industry performance. Let’s break these down:

  • Profitability: Higher profits boost ROE. Companies can improve profitability by increasing sales, controlling costs, and running efficient operations. Investing in R&D can also help by creating new products that attract customers.
  • Debt Levels: Debt can have a big impact on ROE. High debt often reduces ROE because of interest payments, which cut into net income. On the flip side, companies with moderate debt might see a boost in ROE since they’re using leverage without overwhelming expenses. Finding the right balance between debt and equity is important.
  • Industry Performance: How an industry as a whole is doing also affects ROE. Comparing a company’s ROE to the industry average can highlight its competitive standing. Other factors like market trends, regulatory changes, and technology advancements can influence ROE as well.

What are Some Limitations of Return on Equity?

While ROE is a useful metric, it has some limitations that investors should keep in mind:

  • Conservative Measurement: ROE only factors in net income and equity, ignoring debt and other off-balance-sheet items.
  • Industry Variability: ROE varies by industry because of different capital structures, so comparing companies across sectors may be misleading.
  • Short-term Focus: ROE is a snapshot of a particular period and might not reflect long-term potential.
  • Quality of Earnings: High net income doesn’t always mean strong cash flow, which can affect the reliability of ROE.

Because of these limitations, it’s wise to look at other metrics too, like the P/E ratio, to get a fuller picture of a company’s performance.

How Can Companies Improve Their Return on Equity?

To improve ROE, companies can:

  • Increase profitability by growing revenue, cutting costs, and optimizing operations.
  • Manage debt wisely to avoid high interest costs.
  • Make better use of assets to maximize returns.
  • Improve profit margins by refining pricing and reducing expenses.
  • Streamline processes to run more efficiently.

Take Apple, for instance. In the 1990s, Apple’s ROE was low due to financial challenges. But under Steve Jobs, they focused on innovation, expanded their product line, and boosted profitability. This strategy led to a high ROE, eventually making Apple one of the world’s most valuable companies.

What is the Difference Between Return on Equity and Return on Investment?

Both ROE and Return on Investment (ROI) are useful fundamental metrics, but they measure different things. ROE focuses on how profitably a company uses its shareholders’ equity, while ROI looks at the total profitability of any given investment. ROE is calculated by dividing net income by shareholders’ equity, whereas ROI divides net revenue or gross income by the total investment cost. So, ROE is more about a company’s capital efficiency, while ROI gives a broader view of an investment’s overall performance.

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Frequently asked questions

In CANSLIM, ROE supports the “A” for Annual Earnings Growth, helping investors gauge management’s effectiveness in generating returns. William O’Neil, the creator of CANSLIM, found that top-performing stocks often have ROEs of at least 17%, with the best hitting 25% or more. High ROE aligns with CANSLIM’s focus on strong, consistent earnings, as it indicates that a company is profitable, well-managed, and likely to continue growing. ROE is a way to identify companies with high growth potential and efficient operations, key components of the CANSLIM approach.

William O’Neil recommends looking for stocks with an ROE of at least 17% when applying the CANSLIM strategy. The most successful stocks, according to O’Neil’s research, often have ROEs of 25% or higher. High ROE indicates efficient capital use and strong profit generation, making these stocks more attractive to institutional investors. A consistent, high ROE is a positive sign for CANSLIM investors seeking companies with steady growth and effective management.

William O’Neil values a high ROE because it indicates that a company is efficiently turning shareholders’ equity into profits, a sign of strong management and competitive advantage. In his research, O’Neil found that leading growth stocks often had high ROEs, showing they could sustain profitability and reinvest profits to fuel further growth. For CANSLIM investors, a high ROE signals a company with a solid foundation and the ability to drive continued earnings increases.

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