The ROE Metric Is Flawed

Have you ever stopped to marvel at how backwards the venerable return on equity (ROE) equation is?

Sure, generating huge profits from a small shareholder investment is a noble cause. But let's say you're the CEO of a large business, and your compensation (or at least your personal sense of business success) is tied to ROE performance. How do you juice the metric so you can get a nice, fat bonus without necessarily doing outstanding business? Here, let's take a look at the magic formula:

Return on Equity = Net Income / Shareholder's Equity

OK, so the hard way to do it would be to increase profits. There are several problems with that:

  1. It's tough to actually do it, and you have to be great at your job.
  2. More profits in an industry that's not growing normally requires taking market share from competitors.
  3. Higher net profit equals higher taxes.

The first problem is only an issue for the executive in question. Shareholders love managers who go this route despite the tax consequences of reporting high earnings. This school of management includes chip designer Cirrus Logic (Nasdaq: CRUS  ) , chemical giant DuPont de Nemours (NYSE: DD  ) , and generic drug developer Impax Laboratories (Nasdaq: IPXL  ) , all of whom are raising their ROE ratios in conjunction with higher earnings. Three cheers are in order for them, methinks.

But what happens when the obvious route to a higher ROE seems too arduous? The super-easy way out is to take on a truckload of new debt and increase the company's leverage. Breaking ROE down a step further, the equation actually becomes net profit margin X asset turnover X an equity multiplier. The equity multiplier part of the equation is assets divided by equity, so when company's take on debt they boost assets while equity stays flat.

Proponents of boosting debt include used car dealer CarMax (NYSE: KMX  ) , regional telecom service provider CenturyLink (NYSE: CTL  ) , paint purveyor Sherwin-Williams (NYSE: SHW  ) , and next-generation wireless operator Clearwire (Nasdaq: CLWR  ) , all of whom recently took on significant debt to either make a big acquisition or build out a lot of new business capacity very quickly. The jury is out on whether any of these moves actually improved the businesses, but regardless, the added debt gave ROE an artificial boost. Of these, CenturyLink's compensation committee may choose to use ROE as a basis for executive bonus payouts at its discretion.

I'm not saying that you should stay away from CarMax and CenturyLink just because their ROE improvement is leverage enhanced, nor is this an official recommendation to buy Cirrus Logic or Impax Labs. As with any other fundamental metric, ROE comes with its share of pitfalls, and I wanted to point out circumstances that warrant deeper investigation before buying or selling anything.

What's your favorite example of proper or wrongheaded ROE boosts? Share your experience -- good or bad -- in the comments box below.

Fool contributor Anders Bylund holds no position in any of the companies discussed here. CarMax is a Motley Fool Inside Value pick. Sherwin-Williams is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. You can check out Anders' holdings and a concise bio if you like, and The Motley Fool is investors writing for investors.


Read/Post Comments (2) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 22, 2010, at 7:27 PM, TMFRichDad wrote:

    ROE is still the only measure of what shareholders receive, after payments to debt, taxes and allowing for depreciation of fixed assets.

    If leverage concerns you, simply examine the individual components in the decomposition you gave and avoid those with high (relative to market or relative to it's industry):

    ROE = net profit margin X asset turnover X an equity multiplier

    Incidentally, the equity multiplier is better know as the leverage ratio = Assets / Equity. Also, the first two terms are ROA = net margin x asset turnover.

    Simply avoiding companies with high leverage ratios and still earning a high ROE is the approach to take.

    Rich

  • Report this Comment On September 22, 2010, at 9:51 PM, dmb63 wrote:

    This article is not correct for the following reasons

    1) When a firm takes on new debt, assets increase and liabilities. equity does not change, thus ROE does not change. As a company operates there will be interest expense which will impact the net profit margin. Thus overtime it will decrease the first compenent and increase the other making this approach difficult to interpret.

    2) Taking on debt can increase or decrease ROE. A better approach is to break ROE down into operating and financing section to see the impact. Thus, ROE is a function of return on assets (operating) and amount provided by financing. The amount from debt can increase or decrease the ROE as can be seen from the alternate (and better) approach for decomposing ROE.

    ROE= ROA + (ROA-after tax cost of borrowing)Xfinancial leverage

    3) the amount of debt will increase the risk resulting in an increased required cost of debt. This should be factored into compensation.

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