Companies that report losses are more difficult to value than those reporting 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 = 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 percent is considered strong and covers their costs of capital.

When ROE Misleads With an Established Company

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 in lieu 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 a number of charges to restructure its business. This 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 percent. 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 percent.

For astute investors, this could have provided an indication that HP wasn’t in a 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.   

Now, if an organization is always losing money without a good reason, investors should regard negative returns on shareholders' equity as a warning sign that the company is not as strong. For many companies, something as basic 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 their business.

When ROE Misleads on Start-Ups

Most start-up 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 inexpensive prices.

Start-ups 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 stronger ROE than investors might expect.