According to an article in Dr Wealth’s blog, there were more than 68,000 new CDP accounts opened in the past 12 months. Apparently, the number of people who now hold securities is at an all time high of 844,000 people.While it is a fact that more and more Singaporeans are interested in making money from shares, I am not so sure whether these Singaporeans are really investors or merely speculators. Given that the Wall Street is now at record peak, many existing local stockholders’ portfolio have risen in value. I reckon this must have attracted people to open trading accounts and take part in the actions as well. After all, many Singaporeans want to make money and become rich quick. But before newbie traders get carried away, it is important to build the knowledge foundation first.
Last week, one of my readers, Dexter Choo wrote in to me asking why I use Return on Equity (ROE) instead of Earning Per Share (EPS) to measure the financial health of a company. This article is written to clarify some of the strategies I use for stock analysis and hopefully readers can benefit from this sharing and went on to build their wealth.
Basically ROE reveals how much profit the management can generate with the money shareholders invested. Essentially it is a metric that measures how effective the management is in reinvesting the capital of a company. The formulas for ROE and EPS are as follows:
Return on Equity = Net Income/Shareholder’s Equity
Earning Per Share = Net Income/Number of Shares
As many readers know, shareholder equity is equal to total assets minus total liabilities. Sometimes, companies declare dividend payments and this will influence the ROE. This is because dividend payments will reduce the total shareholder equity in the balance sheet and decrease the denominator, resulting in a larger ROE. Therefore, from an investor’s perspective, ROE will be a more meaningful figure compared to EPS as the former can reveal how effectively the management is deploying its retained earnings to make more money for the shareholders. The higher the ROE, the more wealth the management is creating for the company’s shareholders. Generally, a company is considered a good investment if it is able to sustain a double-digit ROE for the last 5-10 years.
Another reason why I favor ROE over EPS is because the former allows me to benchmark performances of the companies in the same industry. I can compare ROE of one company to the other companies or what I can expect to earn by placing the same funds in a bank fixed deposit. EPS on the other hand, reveals how much earning per share. At best, EPS allows you to value the price of a stock but fundamentally, it doesn’t allow you to determine how effective the surplus funds are deployed.