Return on equity is a profitability ratio that measures how much profit a company makes with money that shareholders have invested. In other words, the ROE ratio is reflected in percentage dividing net income (before dividends are paid) by equity (preference shares excluded).
ROE = Net Income / Shareholder’s Equity
The percentage value of ROE determines how well the company uses the cash from the shareholders. Thus, the higher the return on equity the better company operates in the business with equity provided.
The ratio is used as a part of the selection process when analyzing stocks within a sector and industry. Hence, it is mainly used for comparison of companies operating in same segments. For instance, a bank and a construction company are going to have very different ROE ratio levels.
When looking at return on equity of the companies in the same industry, it is obvious that we are seeking a positive ratio. Negative ratios is a sign of inefficient operation of the firm. Furthermore, it is valuable if we spot a trend in a history of ROE. The trendy behavior of the ratio strengthens the overall trend. Thus, an increase in return on equity at least in last two quarters is a positive sign of continues improvement of company profitability.
Below is an example of two chipmakers from the same industry – Semiconductor Broad Line. It is obvious that AMD is not a good choice since the ROE is negative. Until 2nd quarter of 2017, the return on equity was below -100% and not improving. A significant increase of ROE in the 3rd quarter to -13% signals improvement, so if this trend continues, the stock price might induce an attention. So far the ratio is not interesting and its stock price claims the same – it is in consolidation for over a year!
On the other hand, Intel is showing a positive ROE with a steady increase every quarter. This is a great example of a good value stock that keeps in trend. Its stock price claims the same – increasing!
A successful trend trader chooses Intel over AMD in a comparison of return on equity.
Note, the ROE ratio must not be used as the only indicator when picking the stock. It must always be accompanied by other fundamental indicators since there are also other aspects of the firm's engine that drives profitability and valuation.