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.