Return on Equity (ROE)

What It Is:

Return on equity (ROE) is a measure of profitability that calculates how many dollars of profit a company generates with each dollar of shareholders' equity. The formula for ROE is:

ROE = Net Income/Shareholders' Equity

ROE is sometimes called return on net worth.

How It Works/Example:
Let's assume Company XYZ generated $10,000,000 in net income last year. If Company XYZ's shareholders' equity equaled $20,000,000 last year, then using the ROE formula, we can calculate Company XYZ's ROE as:

ROE = $10,000,000/$20,000,000 = 50%

This means that Company XYZ generated $0.50 of profit for every $1 of shareholders' equity last year, giving the stock an ROE of 50%.

Why It Matters:
ROE is more than a measure of profit; it's a measure of efficiency. A rising ROE suggests that a company is increasing its ability to generate profit without needing as much capital. It also indicates how well a company's management is deploying the shareholders' capital.

It is important to note that if the value of the shareholders' equity goes down, ROE goes up. Thus, write-downs and share buybacks can artificially boost ROE. Likewise, a high level of debt can artificially boost ROE; after all, the more debt a company has, the less shareholders' equity it has (as a percentage of total assets), and the higher its ROE is.

Some industries tend to have higher returns on equity than others. As a result, comparisons of returns on equity are generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio should be made within this context.

What is Capitulation?

Capitulation:
Financial capitulation occurs when investors attempt to exit an investment or market so quickly that they are willing to surrender any and all gains to do so. Panicked behavior often causes a capitulation, and investors may attempt to liquidate most or all of their holdings in these circumstances.

How It Works/Example:
A capitulation frequently occurs after a security or a market has endured a long, downward slide in value; it is the final act of hitting bottom. There are four general signs a capitulation is occurring or has occurred.

Significant Changes in Trading Activity
Capitulations commonly involve unusually high trading volumes and price declines, typically over one or two trading days (although they can last longer).

High Levels of Cash Held by Mutual Funds
The presence of large numbers of investors attempting to exit the market by selling their mutual fund shares frequently compels mutual funds to hold high levels of cash in order to meet those demands.

Unusually High Derivatives Activity
Large increases in put purchases or option volatility indexes indicate that investors are either strongly betting against a market increase or are rapidly attempting to hedge against expected price declines.

Continued and Profound Negative Investor Sentiment
Capitulations are most frequently attributed to investors emotionally "giving up," rather than to external forces like changes in the fundamental outlook of a company. This negative investor sentiment may be the cause (or effect) of reaction and opinion communicated by the media, analysts, traders, or other investors.

Why It Matters:
Because capitulations generally reflect the final bottoming-out of a security or market, prices typically increase after a capitulation. Thus, capitulations can signal the beginning of a turnaround in a stock or market.