Why You Should be Suspicious of ROE

by russel_leffingwell

Hi all, just wanted to give a little extra insight on a common little metric that I’ve been seeing thrown around too loosely around various investing subreddits. Thought this would be useful for all your DD efforts.

ROE (Return on Equity) aka Net Income / Average Shareholders’ Equity

People love throwing out ROE numbers to get you to love whatever they are pitching, but you should be automatically suspicious of ROE as a headliner number.

ROE can be written another way: ROE = ROA x Financial Leverage.

ROA is an operating metric.

Financial Leverage is a capital structure metric.

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So ROE is a blended metric of both: operations and capital structure.

This is significant because when you are comparing two competitors and think that one with a higher ROE is a better value play that may be a mistake.

Those two hypothetical companies may have the same exact ROA but company A may just have borrowed heavily, which will jack up ROE. No change in business model, operations, efficiency, etc, just a simple increase in debt will make your ROE go up, even if you just sit on the cash and don’t use it.

Remember, debt is risky for equity holders, no guarantee that a company will use it for productive projects. This risk is further compounded in a near zero rate environment.

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ROA is a more relevant metric if you are commenting on the core business model.

At best, ROE without context is a distraction. At worst, it can be downright misleading.

Happy Investing!

btw this wouldn’t apply to bank stocks

 

Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence or consult your financial professional before making any investment decision.

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