Limitations of Return on Equity (ROE)

Return on equity is a valuation multiple that is commonly used in order to determine the value of a company. The return on equity or ROE is the amount of profit that is generated with the money that has been invested with a company by the shareholders. 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.

Return on Equity

The return on equity calculation is going to tell you whether a company is being efficient with their resources or not. This tells you exactly how much money can be generated for every dollar of equity that a company has. Ideally, you would like to put your money with companies that know how to generate more profit from it. In order to calculate return on equity, you are simply going to take the net income of the company and divide it by the shareholder's equity. This is an easy calculation that can be done in a few minutes in most cases.

Write-Downs

A write-down is a technique that many companies use on a regular basis when valuing assets. When a write-down occurs, the company is going to reduce the value of an asset because they believe that it is currently over value according to market prices. When they do this, it is going to reduce the shareholder's equity significantly without changing the net income. Therefore, you 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 return on equity. Companies will regularly engage in stock buybacks for a number of different reasons. Sometimes, they will actually buy stock back from the market just so that they can affect financial ratios such as return on equity. When a company buys a large number of shares from the market, they are going to reduce the shareholders equity significantly. When the company does this, they are going to also improve the return on equity ratio. Nothing fundamental change with the way that the company was doing business, but the return on equity jumped significantly. 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.

Considerations

When you use return on equity to help in your decision to purchase stock, you are going to want to take into consideration all of these variables. They can all drastically affect the return on equity and your decision to purchase the stock.

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