A:

Companies that report losses are more difficult to value than those that report consistent profits. Any metric that uses net income is basically nullified as an input when a company reports negative profits. Return on equity (ROE) is one such metric. However, not all companies with negative ROEs are always bad investments.

Reported Return on Equity

ROE is calculated as:

Net income / Shareholders’ equity

To get to the basic ROE formula, the numerator is simply net income, or the bottom-line profits reported on a firm’s income statement. The denominator for ROE is equity, or more specifically – shareholders’ equity.

Clearly, when net income is negative, ROE will also be negative. For most firms, an ROE level around 10% is considered strong and covers its costs of capital.

How it can Mislead

A firm may report negative net income, but it doesn’t always mean it is a bad investment. Free cash flow is another form of profitability and can be used in lieu of net income. Below is an example of how looking only at net income can be misleading.

Back in 2012, computer and printing giant Hewlett-Packard Co (HPQ) reported a number of charges to restructure its business. This included headcount reductions and writing down goodwill after a botched acquisition. These charges resulted in negative net income of $12.7 billion, or negative $6.41 per share. Reported ROE was equally dismal at -51%. However, free cash flow generation for the year was positive at $6.9 billion, or $3.48 per share. That’s quite a stark contrast from the net income figure that resulted in a much more favorable ROE level of 30%.

For astute investors, this could have provided an indication that HP wasn’t in as precarious position as its profit and ROE levels indicated. Indeed, the next year net income returned to a positive $5.1 billion, or $2.62 per share. Free cash flow improved as well to $8.4 billion, or $4.31 per share. The stock rallied strongly as investors started to realize that HP wasn’t as bad an investment as its negative ROE indicated.

The Bottom Line

The HP example demonstrates how looking at the traditional definition of ROE can mislead investors. Other firms chronically report negative net income, but have healthier free cash flow levels, which might translate into stronger ROE than investors could realize.

At the time of writing, Ryan C. Fuhrmann did not own shares in any of the companies mentioned in this article.

RELATED FAQS
  1. How do you calculate return on equity (ROE)?

    Return on equity (ROE) is a ratio that provides investors insight into how efficiently a company (or more specifically, its ... Read Answer >>
  2. What is the average return on equity for a company in the oil & gas drilling sector?

    Investing in the oil and gas drilling sector can be a profitable endeavor for some investors, but it is first necessary to ... Read Answer >>
  3. What is the average return on equity for a company in the forest products sector?

    Investing in the forestry sector can provide a hedge against other asset classes, but investors should be aware of the sector's ... Read Answer >>
  4. How do you determine a tangible asset's useful life?

    Learn what the average return on equity for a company in the chemicals sector is and what factors influence changes in the ... Read Answer >>
  5. What is the difference between ROCE and ROE?

    Discover how investors and analysts utilize the return on equity and return on capital employed ratios to gauge financial ... Read Answer >>
  6. What is the average return on equity for a company in the internet sector?

    Find out more about return on equity (ROE), how it is calculated and what the average ROE is for a company in the Internet ... Read Answer >>
Related Articles
  1. Investing

    How Return On Equity Can Help You Find Profitable Stocks

    It pays to invest in companies that generate profits more efficiently than their rivals. This is where ROE comes in.
  2. Investing

    High Return On Equity Businesses

    Companies with high returns on equity usually see an increasing stock price in the future.
  3. Investing

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  4. Managing Wealth

    Understanding the DuPont Analysis

    DuPont analysis measures assets at their gross book value, rather than at net book value, in order to produce a higher return on equity (ROE).
  5. Investing

    Analyzing Amazon's Return on Equity (ROE) (AMZN)

    Learn how to analyze Amazon's return on equity (ROE), especially given the company's focus on capital investments, as opposed to short-term earnings.
  6. Investing

    Analyzing Wells Fargo's Return on Equity (WFC)

    Examine Wells Fargo & Company's return on equity and how stacks up against its major competitors, along with future projections for the company's ROE.
  7. Investing

    ROA And ROE Give Clear Picture Of Corporate Health

    Both measure performance, but sometimes they tell a very different story. This is why they’re best used together.
  8. Investing

    Analyzing Facebook's Return on Equity (FB)

    Learn about Facebook's return on equity (ROE), and find out how it compares to its peers. Discover how net margin, asset turnover and financial leverage impacted its ROE.
  9. Managing Wealth

    Looking Deeper Into Capital Allocation

    Discover how companies decide how to spend their cash in a variety of market conditions.
  10. Investing

    Analyzing Delta's Return on Equity (DAL)

    Learn about Delta Air Lines' return on equity (ROE). Find out how net margin, asset turnover and financial leverage impact its ROE relative to its airline industry peers.
RELATED TERMS
  1. DuPont Identity

    An expression that breaks return on equity (ROE) down into three ...
  2. Equity Multiplier

    The ratio of a company’s total assets to its stockholder’s equity. ...
  3. Net Income - NI

    1. A company's total earnings (or profit). Net income is calculated ...
  4. Bottom Line

    Refers to a company's net earnings, net income or earnings per ...
  5. Return On Average Equity - ROAE

    An adjusted version of the return on equity (ROE) measure of ...
  6. Negative Return

    This occurs when a company or business has a financial loss or ...
Hot Definitions
  1. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  2. Down Round

    A round of financing where investors purchase stock from a company at a lower valuation than the valuation placed upon the ...
  3. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  4. Portfolio Investment

    A holding of an asset in a portfolio. A portfolio investment is made with the expectation of earning a return on it. This ...
  5. Treynor Ratio

    A ratio developed by Jack Treynor that measures returns earned in excess of that which could have been earned on a riskless ...
  6. Buyback

    The repurchase of outstanding shares (repurchase) by a company in order to reduce the number of shares on the market. Companies ...
Trading Center