Every investor wants the companies whose stock they buy to make money. High returns on shareholders' equity typically indicate that a business is financially healthy, but some companies post negative returns on shareholders' equity. Before you reject a company with negative returns on equity, you should figure out the reasons why it is losing money and decide whether the situation is likely to get better. Below, we'll look at why many companies post negative returns on equity while still having good long-term prospects.
Understanding the life cycle of a business
Nearly every start-up company initially loses money. Therefore, if you based your investment decisions solely on returns on shareholders' equity, then you would never invest in a new business, and you'd potentially miss out on buying some great companies early in their histories when their share prices were relatively inexpensive.
Typically, start-ups will have negative shareholders' equity for at least a short period, making returns on equity meaningless. Yet even once a company starts making money and gets rid of the accumulated deficits on its balance sheet, replacing them with retained earnings, you can expect it to sometimes suffer losses.
Why more mature companies can have negative returns on shareholders' equity
The other thing to bear in mind is that return on shareholders' equity is an accounting metric, and accounting rules require it to take into account several items that shareholders might feel entirely comfortable about seeing. For instance, research and development expenses reduce net income and can hit returns on equity, but they also represent a long-term investment in the future prospects of a business.
Similarly, occasional impairment charges and other extraordinary items can temporarily depress earnings. Such one-time charges don't necessarily reflect the fundamental health of a business but can rather be accounting requirements that companies must follow on their income statements.
Of course, if a company is consistently losing money for a reason other than from an artificial accounting-based item, then negative returns on shareholders' equity are a warning sign that it might no longer be as strong as it once was. Many companies have seen increased competition eat into returns on equity and then eventually force them into drastic action to avoid failure.
It's never great to see negative returns on shareholders' equity, but it also isn't always a huge problem. Only by taking it in context of how the company's business is truly faring can you draw the right conclusion from returns on equity.
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