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Monday, August 16, 2010

Fundamental Analysis: Measuring Profitability

The ROE is useful for comparing the profitability of a company to that of other firms in the same industry.

ROE measures a company's profitability by comparing its net income to shareholders equity (book value). ROE is a speed limit on self-funded growth (company's profit). That is, a company cant grow earnings faster than its ROE without raising cash by borrowing or selling more shares. For instance, a 15% ROE means that the company cant grow earnings faster than 15% annually by relying only on profit to fuel growth.

Higher ROE is usually better. ROE, then, becomes a measure not only shows return of the company is generating, but also of how successfully management has been in running the corporation. Good ROE ratio depends on the company's industry. When looking for stocks, we want to find companies that show an increasing ROE over time. It's a sign to us that management is getting better and better at deciding what to do with its money. The higher the number, the better management has allocated capital.

It turns out that a company cannot grow earnings faster than its ROE without raising additional cash. That is, a firm with a 15 percent ROE cannot grow earnings faster than 15 percent annually without borrowing funds or selling more shares. So ROE is a speed limit on a firm’s growth rate. Many specify 15 percent as their minimum acceptable ROE when evaluating investment candidates.

You also must pay attention on the company's debt when calculating ROE. Recall that shareholder’s equity is assets less liabilities. High liabilities means low equity. The higher-debt firm will then show the higher return on equity. Consequently, you should take debt levels into account when comparing different firm’s return on equities.