The global economic recovery is in its sixth year of growth. While the length of recovery has been impressive, the pace has been slower than previous recoveries. In periods of rapid growth, choosing between investing in slower-growing, highly profitable companies or fast-growing companies with lower returns-on-equity (ROEs) can be tough. In these instances, measuring ROE to evaluate investment opportunities can get muddy because the value of the growth can overwhelm the ROE. However, when most firms are growing slowly, as they are now, paying more attention to ROE trends may help investors find market segments poised to outperform.
What is ROE?
ROE is one factor that shows investors whether the businesses they own are working hard for them or not. ROE is calculated by dividing the net income a corporation earns by its book value, which is the value of its assets minus any debts owed. A high ROE means the company produces large earnings from assets financed by stockholders. A low number suggests the business doesn’t earn its owners a high return on their investments.
The structure of businesses and accounting rules can affect the ROE. Technology companies, which have fewer physical assets, tend to have higher ROEs. Utilities, whose power plants and distribution grids often carry considerable value, tend to have lower ROEs.
When evaluating ROE, investors often focus on its current levels, trends and changes. Below are a few examples of how monitoring ROE can benefit investors.
U.S. Stocks Rally out of the Financial Crisis
The chart below shows the ROE for U.S. large caps beginning in 2008. The financial crisis hurt profits, pushing ROEs lower. In 2010, U.S. companies improved profitability dramatically, and the ROE continued to rise into 2011. While the ROE slipped in 2012, it has remained at high levels since 2010. The rapid recovery in profitability, and ongoing high levels, allowed U.S. stocks to post double-digit gains in four of the five years between 2010 and 2014. Even in a slow-growth world, healthy business can produce excellent returns.
Healthcare Rises and Financials Fall