The ROE is at times considered over the price to book value metric as the PB does not take into account the debt of the firm while equity book value is a balance sheet measure. The most important is the net income is quiet useful in capturing the overall operations of the company least of which is the fact that we are only looking at one year earnings to calculate the ROE metric which is effected by the interests the company is liable to pay, the tax policies and by depreciation on assets. This along with other factors makes ROE amongst the most valued and sort after ratios. This makes the ROE an amalgamated return on the firm's combined assets.
Quite a few empirical studies on ROE have reported significant results when it comes to gauging an entities' performance. Besides this investors also use ROE is an indicator of the efficiency of the management in profit generation from its equity.
Misleading??
Investors filtering stocks by their ROE is quiet rational given the support it has both in theories and real life. Even then this metric is not all fool proof as there are circumstances that may lead to misleading ROEs and thus leading investors into pit falls.
Book Value of Equity
Firstly the fact that this measure uses the equity at its book value which is essentially the cost of the equity to the firm which more or less exaggerates the ROE figures. Since most of the companies (besides those involved in financial business) tend to have a lower book value of their assets. For better measure investors should look for the ROE is derived from the market value of the assets to get hold of a true picture of the management's efficiency.
Buybacks!!
Most of the investors believe that the increase in ROE metric is attributed to an increase in net profit of the company. A drop in equity is generally ignored to be a reason. Share Buybacks are one such reason why there could be an equity drop.
When a company announces a buyback, it actually uses the idle cash it possesses on hand to reduce the number of outstanding shares. This activity actually has a doubling effect on the ROE metric. Firstly the buyback reduces equity by reducing Current Assets available in the form of cash. Secondly the buyback reduces the number of outstanding shares bought back. This perhaps is the reason why certain companies engaged in regular buybacks always have a higher than average ROE. The question is can the earnings of such companies be trusted?
Considering the case of Apple Inc. (NASDAQ: AAPL) and Dell (NASDAQ: DELL). Looking into the Quarterly ROE from 2002-2009 of both the firms. It can be seen that while AAPL's ROE went up from 1.62% in the quarter ended on Sept 30, 2002 to 35.31% in the quarter ended June 30, 2009 even registering negative figures in the quarters ended March 31, 2003 and June 30, 2003 with -17% and -49% respectively while DELL's ROE went up from 42.5% in the quarter ending October 31, 2002 to 52.38% in the quarter ending April 30, 2009, and in the midst even hovering upwards of a respectable 70% mark from April 2006 to Jan 2007. But if we compare the stock prices of these firms between the same period we see that while Dell's stock price went from $28.43 on 22nd August 2002 to $13.73 on 30th June 2009 while on the other hand Apple registered a 540% increase from $7.98 on 22nd August, 2002 to $142.43 on 30th June 2009.
CBS Corporation (CBS) trading on NYSE announced a buyback of $1.5 billion approximately 9% of its market capital at that time. This buyback saw its Equity go down to $2.66 from $2.99 (the rest covered by the increase in revenue) resulting in a ROE of 2.88% from a mere 0.65%. But with a Beta of 2.2 CBS still remained a shaky investment that many investors ignored at the time.
Life Technologies Corporation (LIFE) trading on NASDAQ in January announced a buyback of approx 5.5% of their market capital for $0.5 billion. This saw their ROE grow from 1.21% to 1.59% as their Equity went down to $2.14 billion from $ 2.26 billion.
Buybacks are commonly undertaken to return back the wealth to the shareholders but quiet often this is also undertaken to simulate the share prices by improving the financial ratios of the firm.
Sonic Corp (SONC) trading on NASDAQ has recently announced a share buyback of $40.0 million by 31st August 2013 "....and the share buyback will help the company reduce the share count, thereby increasing earnings per share and return on equity. Apart from bolstering shareholders' value, this strategic move will also lift the relatively undervalued share price." (http://finance.yahoo.com/news/sonic-approves-share-buyback-192936855.html)
Although the above discussed CBS, LIFE and SONC had an increase in net profit margin or sales before announcing the buyback the problem can be compounded if a company has suffered a loss and announces a buyback off its Cash on Hand or reserves. Even serious are the complications when a firm decides to buy back its shares by loaning its activity.
Managers often find cheap debts to finance the buyback and in the process improve interest in the company's share quiet tempting. The general tendency of managers is to consider their shares as undervalued no matter what price they are trading at and second is the optimism they have is the continuous growth in the cash flow of the company. Which they could utilize to pay off the debt. If the management's estimations prove futile the consequences are to be bore by the investors.
JB Hi-Fi (JBH) trading on Australian Securities Exchange (ASX) in March 2011 announced a 10% equity buyback chiefly financed by raising its debt. JBH's CEO Terry Smart cited his belief in companies strong cash flow as a reason. 'We continue to take a prudent approach to the management of our balance sheet and we are now in a position to return capital whilst still maintaining financial flexibility to invest in growth opportunities,'' Mr Smart (http://www.smh.com.au/business/strong-cash-flow-prompts-jbs-buyback-20110329-1cdua.html#ixzz24K3pqr2j) As a result companies debt reached AU$233 million from AU$34 million, the ROE more than doubled resulting in the shares price increases slightly between March 2011 to March 2012. One year on and the JBH's shares have lost almost 50% of its value and gone from AU$19.23 on 4th March 2011 to AU$ 9.53 on 23rd August 2012.
Equity
The Equity component of the metric is particularly a tricky one. Highly leveraged firms can have situations where the liabilities exceed the amount of assets, technically making the firm bankrupt since they owe more than they have. This could lead to potential negative values of equity and a negative figure for the ROE. A negative ROE is not an accurate measure of the firm's performance and hence is regarded the same from many analysts. This is the reason why many firms do not report the figure at all. But curious investors can still get these numbers from any stock screener which produces this metrics in negative upon request. The stock screens generally tend to rank companies with such ratios as the worst performers, below any firm having positive value. A negative ROE is a useless metric and should not therefore be used as a tool to measure the firm's efficiency.
It is interesting here to note that just before the equity drops below "zero" the ROE peaks. A classic case here is that of the Coca Cola (KO) It can be seen that the total assets of KO went up 67% from 467.972 in 1990 to 785.196 in 1991 with the total liabilities registered a somewhat near growth of 90% in the same period while the ROE remained the same 1.4% (the offset being covered by the rise in net income from 0.229 to 2.936). The picture changed altogether in 1992 where the 32.76% rise in total liabilities could not be matched by the rise in total assets of a mere 0.086% and this was compounded by a 29.05% decrease in Net Income aswell, together all these factors led to an increase of ROE to 8.1% from 1.4% in 1992, a figure which is considered respectable by any investor!! It is important here that in this case the ROA would have been a better measure which went from 0% in 1990 to 0.4% in 1991 to 0.3% in 1992. Issues such as these raise question to the use of ROE as a measure of the firm's performance.
Not to mention the problem can be compounded further in cases where there is negative income complimenting a negative equity. This would again give rise to a positive ROE which will again be gravely misleading.
Comcast Corporation (now split into CMCSA and CMCSK) trading on NASDAQ was reeling from dreadful performance between 1990 to 1995 yet it is interesting to see here that the ROE (except in 1991) was looking more than healthy and actually really inviting ranging from 4.6% in 1995 to an eye popping 822.6% while the net income along with equity remained in negative figures. Once again if we look at the ROA which produced figures directly correlated with the net income. It can be once again said that ROA in this situation would have been much better measure.
A lot of empirical studies have been done in the past taking Book value of Equity as a metric for the overall firm's performance of which 8 studies were published in journal of finance (a four star journal) in 2000 alone ( Schwert, 2000, Kang, Shivdasani and Yamada, 2000, Fama and French, 2000, Iskandar-Datta and Patel, 2000 Chaplinsky and Ramchand, 2000, Garella and Guiso, 2000 and D'Mello and Shroff, 2000)
The researchers did make efforts to overcome the problem. Fama and French (2000) "do not use negative BE [book value of equity] firms when calculating the breakpoints for BE/ME [ratio of BE to market value of equity] or when forming the size-BE/ME portfolios.". D'Mello and Shroff (2000) did not include firms with negative equity. Schwert (2000) have excluded firms with very high ROE. However it is apparent from the cases above that such measures are not enough especially when the credible researchers cite the results of their empirical studies which is sadly highly valued among the investors and analysts and continues to effect the global stock markets.
There exists a significant difference between the risk and magnitude generated by the firms cash and operating asset holdings. It is due to this that the firms with significant cash on hand tend to have a low ROE.
