Return on equity, or ROE, tells investors how much in profit a company makes for every dollar it has in stockholder equity on its balance sheet. However, in some cases, the amount of stockholder equity that a company has is actually negative. The return on equity will therefore also be negative if the company earns a profit, and that can produce a misleading result that requires you to draw different conclusions from what you'd ordinarily think.
The typical return on equity situation
Ordinarily, a profitable company produces positive net income, and so if stockholder equity is positive, then the return on equity will also be positive. Dividing return on equity by stockholder equity will give you the ROE. Typically, the higher the ROE figure, the more effectively the company is using its equity to generate profits.
Two situations in which ROE can be negative
However, there are situations in which stockholder equity will be negative. For example, if the company has had a history of losing money and has incurred debt in order to finance continuing business operations, then liabilities will often exceed assets, resulting in negative stockholder equity.
If negative stockholder equity is negative, then dividing a positive profit by the negative figure will result in a negative ROE. This can be misleading because one would typically think that a negative financial ratio indicated a loss. In fact, ROE will also be negative if the company loses money and has positive stockholder equity. Yet between these two negative ROE situations, having positive profits and negative stockholder equity is more indicative of a potential future rebound than having negative profits and positive stockholder equity.
Assessing ROE when stockholder equity is negative
When stockholder equity is negative, the typical rules for evaluating ROE are flipped. In this case, an extremely high negative number can be the best indicator of success, because positive profits are high compared to the negative stockholder equity amount. By contrast, a low negative number shows that the profits are small compared to the negative stockholder equity balance.
Even worse, a positive ROE when stockholder equity is negative is only possible when the company is losing money. A net loss on the bottom line divided by negative stockholder equity produces a positive ROE, but this combination is the worst for the company and its shareholders.
Many investors simply think of return on equity as being meaningless in a negative stockholder equity situation. You can actually draw some conclusions from the figures, but you have to remember that the rules for assessing ROE accurately are almost the reverse of the typical situation.
Want to learn more about stocks and how to start investing today? Check out The Motley Fool's Broker Center and find the right broker for you.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.