Companies that report losses are more difficult to value than those reporting consistent profits. Any metric that uses net income is 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.
- Return on equity (ROE) is measured as net income divided by shareholders' equity.
- When a company incurs a loss, hence no net income, return on equity is negative.
- A negative ROE is not necessarily bad, mainly when costs are a result of improving the business, such as through restructuring.
- If net income is negative, free cash flow can be used instead to gain a better understanding of the company's financial situation.
- If net income is consistently negative due to no good reasons, then that is a cause for concern.
- New businesses, such as startups, typically have many years of losses before becoming profitable, making return on equity a poor measure of their success and growth potential.
Reported Return on Equity (ROE)
ROE = Net income / Shareholders’ equity
When net income is negative, ROE will also be negative. For most firms, an ROE level around 10% is considered strong and covers their costs of capital.
When ROE Misleads on Established Companies
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 measured instead of net income.
Here is a good example of why looking only at net income can be misleading:
Back in 2012, computer and printing giant Hewlett-Packard (HPQ) reported many charges to restructure its business. The charges included headcount reductions and writing down goodwill after a botched acquisition. These charges resulted in a 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 and resulted in a much more favorable ROE level of 30%.
For astute investors, this could have indicated that HP wasn’t in a precarious position as its profit and ROE levels showed. 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 then rallied as investors started to realize that HP wasn’t as bad an investment as its negative ROE indicated.
Now, suppose an organization is always losing money without a good reason. In that case, investors should regard negative returns on shareholders' equity as a warning sign that the company is not as healthy. For many companies, something as simple as increased competition can eat into returns on equity. If that happens, investors should take notice because the company is facing a problem that's core to its business.
When ROE Misleads on Startups
Most startup companies lose money in their early days. Therefore, if investors only looked at the negative return on shareholder equity, no one would ever invest in a new business. This type of attitude would prevent investors from buying into some great companies early on at relatively low prices.
New businesses have losses in their early years due to costs from capital expenditures, advertising expenses, debt payments, vendor payments, and more, all before their product or service gains traction in the market.
Startups will usually continue having negative shareholders' equity for several years, rendering returns on equity meaningless for some time. Even once a company starts making money and pays down accumulated debts on its balance sheet, replacing them with retained earnings, investors can still expect losses.
The Bottom Line
The HP example demonstrates how subscribing to the traditional definition of ROE can mislead investors. Other firms that chronically report negative net income, but have healthier free cash flow levels, might translate into a higher ROE than investors might expect.