Grading Management with ROE

This week I want to talk about Return on Equity.

Return on Equity, or ROE, is a commonly used measure of management efficiency. It's a favorite screening criteria of many money managers, investors and myself, because it tells you how successfully a company is using its shareholder's capital.

Moreover, companies with steadily increasing ROEs are generally better managed with attention being paid to the details.

Criteria Defined

Return on Equity shows how much profit a company is making on its shareholder equity (which includes reinvested earnings).

The formula for ROE is calculated as:

Net Income / Shareholders Equity (past 12 months)

The Income number for a company is listed on their Income Statement.

Shareholders Equity is the difference between Total Assets and Total Liabilities, and is found on a company's Balance Sheet.

ROE is always expressed as a percentage. So a company with an ROE of 10%, for example, means it created 10 cents of assets for every one dollar of shareholder equity in a given year.

How to Use

I think ROE is a great item to use regardless of what kind of investor you are – whether it be Growth & Income or Value. Aggressive Growth or Momentum. Seeing how a company makes use of its equity and the return it makes is an important measure to look at.

It can also alert you to problems when it's falling.

Take Washington Mutual (WM) for example. Granted, there were lots of warning signs to WaMu's demise, but its Return on Equity numbers showed plenty of problems.

Early in the second quarter of 2006, WaMu traded as high as $44.87. Its first quarter's ROE was 14.34%. But by the end of the second quarter, the stock was off its highs and its ROE was lower at 14.08%.

As WaMu's ROE declined quarter after quarter after quarter, to 13.44%, then 12.62%, then 12.05%, etc., its stock price eroded as well.

Finally, by the end of 2007, its ROE was more than cut in half and its stock price down by over 70%.

WaMu in 2008 was showing a negative ROE and, as of last week, they marked their place in history by becoming the largest US bank failure ever. JP Morgan has since acquired them.

Quarterly price chart of Washington Mutual with ROE overlay

Screening for ROE on Zacks.com

You can start screening for ROE on Zacks.com's free screener right away. (See image below.) Under the "Select Category" section, choose Return on Investment. Then in the "Choose Criteria" section, select Current ROE (TTM or Trailing Twelve Months). You'll also see a question mark next to the item. If you don't know what an item means or how to use it, just click on the question mark and a helpful definition will pop up.

Zacks also has several screening strategies that use the Return on Equity measure in our Predefined Screens section within Zacks.com's screener.

Improve Your ROE Screening Results with the Research Wizard

Another great way to use the ROE is to compare it to its Industry.

Some industries require greater assets than others to run their business. Take for instance the Steel Industry versus the Software Industry, for an extreme example. (Steel has a median ROE of 23% while the Computer Software-Services has a median ROE of 7%.)

If you screened for only absolute numbers, you may miss some great stocks in some great groups.

So trying to find companies with the best ROEs relative to their group (Sector or Industry, etc.) is one of the best ways of making an apples-to-apples comparison in an effort to find the top stocks.

The image below shows how to do this in the Research Wizard program.

Conclusion

ROE can be a powerful screening criteria for measuring how effective management has become and how profitable they are in using investors' cash.

And better understanding the factors that affect ROE, and how to best use it, will help make this criteria even more valuable to you.

Here are 5 stocks from a screen I'm running that look for companies with ROEs above their 5-year average and better than their Industry's average (as of 9/29/08):

HPQ - Analyst Report Hewlett-Packard Co.
MANT - Snapshot Report ManTech International Corp.
PSS - Snapshot Report Collective Brands, Inc.
STE - Snapshot Report Steris Corp.
SYKE - Snapshot Report Sykes Enterprises, Inc.

Resources

Free Screener on Zacks.com: Start screening with ROE along with over 100 other criteria to find stocks that meet your needs.

Research Wizard: There is simply no better tool to create and backtest winning screens than with the Research Wizard. Along with Return on Equity, you'll have more than 650 different items to choose from along with access to some of our best proven, profitable strategies.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.