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. What level of return on equity is common for bank?

    Discover what the average return on equity (ROE) ratio is for companies in the banking industry, and understand the significance ... Read Answer >>
  2. What is the average return on equity for a company in the financial services sector?

    Learn the importance of calculating a company's return on equity and what businesses in the financial services industry average ... Read Answer >>
  3. What is the difference between ROCE and ROE?

    Compare these two metrics and see how return on equity and return on capital are employed ratios to gauge corporate performance. Read Answer >>
  4. What are the main differences between return on equity (ROE) and return on assets ...

    ROE gauges how their investments are generating income; ROA measures how management is using its assets or resources to generate ... Read Answer >>
  5. Does a high price-to-book ratio correlate to ROE?

    Learn the correlation between price-to-book (P/B) ratio and return on equity (ROE) and why it can be helpful to use the two ... Read Answer >>
  6. How do you calculate return on equity (ROE) in Excel?

    Find out more about return on equity, the formula to calculate ROE and how to calculate this measure of a company's profitability ... Read Answer >>
Related Articles
  1. Investing

    Analyzing BP's Return on Equity (ROE)

    Examine the return on equity (ROE) for British Petroleum, the slumping international energy company that seems to be falling behind its competitors.
  2. 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.
  3. Investing

    Decoding DuPont Analysis

    Get a deeper understanding of ROE with these three-step and five-step calculations.
  4. Investing

    Analyzing Apple's Return on Equity (AAPL)

    Learn about Apple's return on equity (ROE) in fiscal 2015, and find out how net profit margin, financial leverage and asset turnover impact ROE relative to its peers.
  5. Investing

    Analyzing GE's Return on Equity (GE, MMM)

    Analyze the return on equity (ROE) of GE, and understand the factors that drove it sharply from positive to negative in the year 2015.
  6. 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.
  7. Investing

    Analyzing Verizon's Return on Equity (ROE) (VZ)

    Learn about Verizon's return on equity and find out how ROE is influenced by net profit margin, asset turnover ratio and financial leverage.
  8. Investing

    Analyzing Boeing’s Return on Equity (ROE) (BA)

    Learn about Boeing's return on equity and find out how the company's ROE compares to its own historical performance and aerospace industry peers.
  9. Investing

    7 High-Return Stocks to Survive Market's Chaos

    Goldman Sachs compiled a list of 50 stocks forecast to have the best ROE growth in the next year.
RELATED TERMS
  1. Return on Equity (ROE)

    Return on equity refers to the profitability returned in direct ...
  2. DuPont Identity

    An expression that breaks return on equity (ROE) down into three ...
  3. DuPont Analysis

    DuPont analysis is a fundamental performance measurement framework ...
  4. Equity Multiplier

    The ratio of a company’s total assets to its stockholders’ equity. ...
  5. Profitability Ratios

    Profitability ratios are a class of financial metrics that are ...
  6. Negative Return

    A negative return occurs when a company or business has a financial ...
Trading Center