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.

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