A high ROE may not be as good as a low ROE
ROE ( Return On Equity) is a common metric used to gauge the competency of the management. ROE is calculated by dividing the net profit by the shareholders’ equity and expressed as a percentage. Most people think that a higher ROE is better than a lower ROE. Let see whether this is true.
Shareholders’ equity is the total assets minus the total liabilities.
Consider this scenario: Company ABC has a paid-up capital of 1000, net earnings of 100 and zero debt. Thus its ROE is 10%
Company XYZ also has a paid-up capital of 1000 and earnings of 100, but it has debt of 200. So its ROE is 12.5% (100x100/800)
Assuming that both companies are in the same business. Which is the better company?
Company ABC has a lower ROE than Company XYZ, but obviously it is the better company.
ROE is a useful metric only when you know how to use it intelligently.
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