Many investors are familiar with and understand P/E ratio, market capitalization, and other basic financial metrics as a part of analyzing the fundamental health of a stock. However, many traders are not well versed in a very useful ratio for screening and comparing stocks in an industry: Return on equity (ROE).
Return on equity, at its most basic, is a ratio of net income divided by net assets. It is sometimes averaged over time and referred to as return on average equity. Either way, it's a very useful measure because it considers many other ratios as part of its calculation.
But here's the other key: It is only useful if you can compare it to stocks within similar industries or the same sector. An ROE in one industry may be very good, whereas the same score in another sector might be underperforming.
Take the semiconductor industry. Cree, Inc (CREE) is currently seeing growth and recently issued improved guidance on its performance. The stock is trading at one-year highs and currently has a return on average equity of 1.37%.
First Solar, Inc. (FSLR) is similarly in the semiconductor industry, but this stock boasts an average ROE of over 36%. This tells you that FSLR is much better, over a recent period, at turning assets into income.
Another member of the sector, QLogic Corporation (QLGC) saw over 8% gains on a recent Tuesday and has shown a recent upward trend. This stock's ROE is nearing 10%, which puts it somewhere in between our previous examples. Advanced Semiconductor Engineering (ASX) shows a similar average ROE of just over 10%, while industry goliath Texas Instruments Incorporated (TXN) comes in at just over 11%.
Now, using any one indicator alone for your fundamental analysis isn't a good idea. So make sure the companies you are analyzing don't have any extenuating circumstances that are skewing ROE, like an acquisition or some kind of write off. But when used properly, return on equity can provide a great tool for picking the cream of an industry group.
By John Jagerson of LearningMarkets.com.
