<\/a><\/figure><\/div>\n\n\n\nYou see that debt makes ROE higher because shareholder’s equity goes down. Yet, the ROE generated is misleading with respect to how effectively the company is being managed.<\/p>\n\n\n\n
As a rule of thumb, firms create value for their shareholders if the return on equity is greater than the opportunity cost of the invested funds. That means that the expected return required by the shareholders to invest in the company should be higher than the return on alternative forms of investment with a similar level of capital risk. So, you may have a company that uses all its net income, borrows more money than it has raised by its stock offerings, buy back shares and distributes dividends, thereby creating a negative shareholder’s equity. As the shareholder’s equity portion of the calculation continues to shrink, the ROE metric gets larger.<\/p>\n\n\n\n
Limitations<\/strong><\/p>\n\n\n\nGenerally, companies with a higher debt ratio have a better ROE. A higher ROE allows a company to invest less of its own funds to achieve its growth goals and leaves the company with more capital available to use either on share buyback or to pay an extra dividend. Also, as seen already, debt can technically increase the ROE. On the other hand, a higher debt raises a red flag for bankruptcy. So, these strategies could improve ROE, but they do not create long-term value for shareholders.<\/p>\n\n\n\n
ROE is also a matter of good management. If a firm simply retains its earnings waiting for them to yield a 4% annually in a savings account, it does not create value for its shareholders. So, as a value investor, you need to look for firms whose ROE considers the retained earnings from previous years as well as the company\u2019s debt. In that way, you will be able to know how effectively your capital is being reinvested.<\/p>\n\n\n\n
Summing up, ROE can serve as a valuable metric to find interesting, prominent investments. But this is not enough. You should make sure to compare the ROE of the firm you are interested in investing to the ROE of similar companies in the industry. Become a financial analyst for a while and look into the firm\u2019s debt and equity structure. For value investors, ROE should become a tool for long-term growth, provided that you spot on companies capable of generating a continuous, high return on equity over many decades.<\/p>\n","protected":false},"excerpt":{"rendered":"
A return on any investment refers to the return of capital achieved over a certain period of time. In financial statement analysis, we are using many different ratios to understand how effectively a company is using its assets or its resources to generate a profit and create value for its shareholders. Yet, some of the […]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"om_disable_all_campaigns":false,"footnotes":""},"categories":[5970,931],"tags":[792,925],"yst_prominent_words":[],"_links":{"self":[{"href":"https:\/\/einvestingforbeginners.com\/wp-json\/wp\/v2\/posts\/6205"}],"collection":[{"href":"https:\/\/einvestingforbeginners.com\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/einvestingforbeginners.com\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/einvestingforbeginners.com\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/einvestingforbeginners.com\/wp-json\/wp\/v2\/comments?post=6205"}],"version-history":[{"count":1,"href":"https:\/\/einvestingforbeginners.com\/wp-json\/wp\/v2\/posts\/6205\/revisions"}],"predecessor-version":[{"id":21366,"href":"https:\/\/einvestingforbeginners.com\/wp-json\/wp\/v2\/posts\/6205\/revisions\/21366"}],"wp:attachment":[{"href":"https:\/\/einvestingforbeginners.com\/wp-json\/wp\/v2\/media?parent=6205"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/einvestingforbeginners.com\/wp-json\/wp\/v2\/categories?post=6205"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/einvestingforbeginners.com\/wp-json\/wp\/v2\/tags?post=6205"},{"taxonomy":"yst_prominent_words","embeddable":true,"href":"https:\/\/einvestingforbeginners.com\/wp-json\/wp\/v2\/yst_prominent_words?post=6205"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}