- Issues
- Timing
- Net income assumed to be generated by the equity at the start of the year, thus ROE = Net Income n / Equity n -1
- Some people prefer to use the average of the equity invested at the beginning and end of the year, ROE = Net Income n / avg (Equity n -1 + Equity n)
- Some just use the equity at the end of the year, ROE = Net Income n / Equity n
- Formula 2 and Formula 3 will under-estimate the ROE as the denominator is a larger value. It can be significant for highly profitable companies with large retained earnings when using the ending Equity.
- Treatment of Cash
- ROE is a composite return on all of its assets – cash and operating.
- Cash is very different, both in terms of risk and return, from operating assets - ROE for firms with significant cash balances will be depressed by the low and riskless returns earned by cash
- ROE for operating assets = [Net Income – Interest from cash*(1-tax rate)] / (BV of Equity –cash)
- Minority Interest
- If a firm has consolidated the financial statements of its subsidiary companies. ROE = Net income attributeable to SH/ Total Shareholder Equity
- The difference is actually small and generally is insignificant.
- Pitfalls
- Write-Downs
- Many companies use this technique to reduce the value of its assets.
- If new management comes into poorly performin company, they prefer to write down assets - to prevent it adversely affecting their future performance
- It will get a large jump in the return on equity even though nothing actually changed.
- Buybacks
- Share buyback when share price is grossly undervalued is good for the company by decreasing its share capital, and increasing its EPS.
- 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
- ROE does not take into consideration the amount of debt of a company.
- 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.
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