The pitfalls of excessive focussing on ROE

Return on equity (ROE) is the amount of profit that is generated with the money that has been invested with a company by the shareholders. It is commonly used in order to determine the financial performance of a company and if its stock is good for investment. ROE has proven enduring. It gives you a quick and easy to understand metric.

While this metric can be useful in certain cases, it definitely has a few drawbacks to be aware of as well. Here are a few things to consider about the limitations of return on equity.

Write-Downs

A write-down is a technique that many companies use to reduce the value of its assets that it is currently over value according to market prices. When a new management comes into a poorly performing company, they prefer to write down assets so as not to let them adversely affecting their future performance. When they do this, it is going to reduce the shareholder's equity without changing the net income. Therefore, they are going to get a large jump in the return on equity even though nothing actually changed.

Buybacks

Stock buybacks can also have a drastic effect on ROE. Share buyback, when done when the share price is grossly undervalued is good for the company by decreasing its share capital, and increasing its earnings per share with a reduced number of shares in the market. However, management will actually buy stock back from the market just so that they can improve the financial ratios such as return on equity. Nothing fundamental change with the way that the company was doing business, but the return on equity jumped significantly. Sometimes management even buy back shares even when they are overvalued, with borrowed money. This is a major reason that financial ratios like return on equity have to be taken with a grain of salt when valuing a company.

Debt

Another big problem with return on equity is that it does not take into consideration the amount of debt of a company. It only takes into consideration the net income and the shareholders equity. Therefore, a company could have massive amounts of excessive debt and still look like it is handling things well according to the return on equity calculation. Even though it might show a good ratio, it could be close to crumbling because it has more debt than it can handle and make the company more risky in times of economic downturn or financial crisis.

Intangible assets

Another pitfall of ROE concerns the way in which intangible assets are excluded from shareholder's equity. Generally conservative, the accounting profession normally omits a company's possession of things like trademarks, brand names, and patents from asset and equity-based calculations. As a result, shareholder equity often gets understated in relation to its value, and, in turn, ROE calculations can be misleading.

For example, BAT possesses a trademark in his brand and this “growth asset” is not included in its physical asset but could be even much more valuable than the physical assets it owns.

BAT may very well capitalizes it expense in advertising, and hence lower the operating cost, and as a result, increases its net profit or return, and hence overstating its ROE.

Other examples like EAH, Brahim etc which have little physical assets but heaps of “Goodwill”, something bought way above its book value. After adjusting for intangibles, the company would be left with little assets and shareholder equity base. ROE measured this way would be astronomical but would offer little guidance for investors to gauge efficiency.

Conclusion

ROE can obscure a lot of potential problems. If investors are not careful, it can divert attention from business fundamentals and lead to nasty surprises. Companies can resort to financial strategies to artificially maintain a healthy ROE, even though operational profitability is eroding, just to keep investors happy.

But let's face it, no single metric can provide a perfect tool for examining fundamentals. But contrasting the average ROEs within a specific industrial sector for a few years does highlight companies with competitive advantage and with a knack for delivering shareholder value.

Think of ROE as a handy tool for identifying industry leaders. A high ROE can signal unrecognized value potential, so long as you know where the numbers are coming from.