Return On Equity (ROE) is a measure of how efficient a company is at generating profits.
To calculate the value of a company’s stock we need to consider the profitability of that company. It is important to understand that profitability is not the same as profit.
Profitability takes into consideration the amount of capital required to generate that profit. This is known as Return On Equity. Return On Equity is calculated by dividing the amount of profit by the shareholders’ equity employed. It is usually presented as a percentage.
Put simply, it makes a difference to a company’s value if a profit of $100,000 was generated from a capital base of $1 million or $10 million – that is, an ROE of either 10% or 1%.
StocksInValue calculates Return On Equity and uses it in the valuation of a company and its shares.
In our systems, we “normalise” the profitability to exclude any one-off, non-recurring, adjustments to the bottom line and to add back franking credits. That way, our valuation is more appropriate.
Once the real profitability of a company has been established, we are in a position to begin to identify what value we should be attributing to that company’s stock.
By taking advantage of a realistic valuation and comparing it to the current market price, there is potential to make solid returns over the long haul, whilst minimising risk.