Wednesday, December 16, 2015

ROE Can Be Misleading

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. 

Join my Telegram Super Group to learn more. Message me at 016 932 1849 to join.