4 Reasons ROE Is Not A Useful Metric For Investors

4 Reasons ROE Is Not A Useful Metric For Investors…more attention to return on invested capital (ROIC)

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Recently, we ran through the various flaws in the price to earnings ratio and explained why investors need to be paying more attention to return on invested capital (ROIC). This week, we’re tackling another of the market’s favorite metrics, return on equity (ROE).

Return on equity has a very simple formula:

It’s tempting to think of ROE as just an easier-to-calculate version of ROIC. All you need to do is just find the Net Income line on the Income Statement and divide it by the Shareholder’s Equity line on the Balance Sheet. Unfortunately for investors, a metric that’s so easy to calculate is rarely going to be useful in terms of explaining valuation, as Figure 1 proves.

Figure 1: ROE Has Almost No Impact On Valuation

Sources: New Constructs, LLC and company filings.

Figure 1 shows the relationship (or lack thereof), between ROE and enterprise value/invested capital, which is a cleaner version of price to book. Less than 1% of the difference in valuation between S&P 500 companies can be explained through ROE. A similarly nonexistent relationship shows up when we plot ROE against the P/E ratio.

Figure 2: ROE Doesn’t Impact P/E Either

This evidence is clear. No meaningful relationship exists between ROE and P/E or enterprise value/invested capital[1]. It has an appealing simplicity, but ROE has several fatal flaws that keep it from being a useful metric.

Flaw #1: It’s Based On Accounting Earnings

I’m not going to belabor this point because it’s one we’ve made time and time again. Reported net income is not a useful metric for equity investors. GAAP rules were designed for debt investors, and GAAP net income has a number of issues that make it especially poor at measuring profitability.

  • It contains many accounting loopholes that can distort reported earnings.
  • There’s almost no enforcement in place to keep executives from manipulating earnings.
  • Changing accounting rules and differing interpretations mean net income is not necessarily comparable over time or between different companies.
  • Financing costs such as interest can impact reported earnings, obscuring the actual operating performance.

ROIC fixes these issues by using net operating profit after tax (NOPAT) as the numerator. Unlike GAAP net income, NOPAT excludes financing costs, uses consistent rules across all companies and timeframes, and adjusts out the impact of unusual items and changing management assumptions.

Flaw #2: It Ignores Off-Balance Sheet Items

Companies have all sorts of tools they can use in order to hide assets off the balance sheet. One of those tricks, using operating leases as off-balance sheet debt, is going to get taken away in 2018. Still, there are other hidden off-balance sheet items, such as reservesdeferred compensation, andasset write-downs.

These all represent committed uses of capital for which the company is not being held accountable. This is an area where we really see how accounting rules are geared towards the needs of debt investors rather than equity investors. Writing-down assets helps debt investors by giving a clearer picture of the liquidation value of a company, but it hurts equity investors by obscuring the true amount of capital invested in the business.

We use invested capital for the denominator in our ROIC calculation because it factors in these hidden items so that the company is being held accountable for all of its uses of capital.

Flaw #3: ROE Can Be Influenced Through Leverage

A true measure of profitability should be focused on the operating side of the equation, without allowing financing decisions to have a big impact. By only using shareholder’s equity as the denominator, ROE becomes extremely susceptible to financing decisions, as a company can significantly boost ROE by taking on more leverage and increasing its risk.

The opposite also holds true. A company holding a great deal of excess cash will be penalized with a lower ROE, even though it may be making the responsible decision to hold that cash until a more opportune time arises to invest it at a higher return or to return that cash to shareholders more efficiently.

As an example, let’s look at Nordstrom (JWN) and Apple (AAPL). According to ROE, Nordstrom is the more profitable company, with an ROE of 47.9% compared to Apple’s 44.7%. This misleading comparison stems from the fact that Nordstrom’s total debt is equal to 41% of its market cap, whereas Apple has over $130 billion in net cash (20% of market cap).

When we remove the impact of leverage and just look at the operating profitability of these two companies, we can see that Apple has an ROIC that is more than 10 times higher than Nordstrom.

Flaw #4: Executives Have An Interest In Manipulating ROE

ROE is another one of the “advanced” or “non-GAAP” metrics that companies often use to set performance targets that executives need to hit to earn their annual and long-term bonuses. Consequently, executives will be more likely to manipulate accounting earnings, structure transactions to keep them off the balance sheet, and take on more leverage in order to boost ROE.

Because ROE is so easy to manipulate, and because executives potentially have such a strong interest in artificially boosting it, investors can’t know whether that ROE number is reliable or just a result of financial wizardry. One company might have a significantly higher ROE than a competitor simply because it’s more aggressive exploiting accounting loopholes rather than being superior in terms of profitability.

The ease with which ROE can be manipulated, as well as its various structural flaws, explain why it has almost no value in terms of explaining differences in valuation. As we see so often in the market, simplicity is not always a virtue. ROIC might not be as simple to calculate, but it’s a much better indicator of profitability and valuation.

Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme.

[1] We explore the often misunderstood relationship between ROE and price-to-book in this report.



Consigli per imprenditori alla ricerca di capitali e servizi business

Consigli per imprenditori alla ricerca di capitali e servizi business

Niente più dei numeri sbagliati può affondare una grande idea imprenditoriale!

There has never been a better time to be an entrepreneur (in US, Malta ….not everywhere!)

The current free flowing seed stage capital is giving lots of founders a false sense of confidence when going into their Series A. The result is a lot of busted rounds, limiting these companies’ potential.

The good news is that startups don’t have to fall into the Series A trap. There are a lot of opportunities to capitalize on these same trends and use them to your advantage

“The Blessing of a Skinned Knee.” The book was full of contrarian wisdom. While most new parents’ natural instincts are to improve their child’s life by removing obstacles, eliminating every potential source of pain, and helping them avoid adversity, the author of the book cautioned against overprotecting your child. Specifically, her thesis was that grit and resilience are extremely important life skills, and that it is important for people to learn how to overcome adversity (like a skinned knee) at a young age.

The way that seed funding is all about your idea and team, Series A is all about the numbers. We weren’t tracking cohorts or anything at all. I didn’t know about LTV or CAC, or how to answer questions about the economics of scale. We walked into an interrogation that we weren’t prepared for.”

Loan-To-Value Ratio – LTV Ratio

Customer Acquisition Cost

Series A investors are always looking to catch a company before they run an official process, as it’s almost always in their best interest to pre-empt a competitive funding situation. That means that they’re aggressive in trying to get early meetings. As first-time founders see their inboxes fill with email from VCs, they often assume that the volume and intensity of VC interest will translate into an easy funding round — and often (mistakenly) decide to start a fundraising process too soon.

There’s nothing like numbers to fuck up a good story.


Seed stage boom


Servizi Business per migliorare la propria forma per affrontare le sfide di domani

Confronto di Idee e Azioni per la Corporation e il suo Board, l’Imprenditore e la sua Impresa

Malta, Italia, in Europa, nel Mondo


Soluzioni per per la Corporation e il suo Board, l’Imprenditore e la sua Impresa, a Malta, Italia, nel Mondo

 Dallo spirito del continuo agire e migliorare, dal pensiero globale per un’azione locale che caratterizza MALTAway, è scaturita una nuova proposta:


(download pdf personal trainer) 

Migliorare la propria forma per affrontare le sfide di domani

Confronto di Idee e Azioni per per la Corporation e il suo Board, l’Imprenditore e la sua Impresa

 Con MALTAway, un continuo confronto di Idee e Azioni per l’Imprenditore e la sua Impresa, perché condividere la conoscenza e fare sistema è la strada per la prosperità.

La metafora sportiva, ben si adatta alla sfida e opportunità di successo, che la globalizzazione  presenta.

Per essere vincenti occorre il Board, il CeO, l’Imprenditore e il suo piacere di fare Impresa, allenamento, una squadra affiatata, chiarezza dei propri obiettivi, un personal trainer con cui confrontarsi per contribuire a disegnare la strada.

E tutti questi elementi sono già tutti presenti qui, a MALTA, collante efficace di questa sfida.

Possiamo operare con te, al tuo fianco nel Consiglio di Amministrazione come Non-Executive Director, ma anche insieme al tuo Leadership Team


Costruire con per la Corporation e il suo Board, l’Imprenditore e la sua Impresa un tavolo di confronto strategico, idealmente con alcuni incontri mensili, affiancandolo nelle scelte chiave di Business, basato su questi valori e fondamenta:

  •  Fiducia
  • Rapporto Personale
  • Ascolto e Comprensione del contesto
  • Competenza ed Esperienza
  • Riservatezza


  • Strategia e Governo dell’Impresa:
  • Board Governance
  • Board with Shareholders
  • Board with the Leadership Team
  • Strategia dell’Imprenditore come Azionista
  • Strategia dell’Imprenditore come Capo Azienda
  • Ruolo della famiglia, cambio generazionale
  • Capitali di rischio e Investments
  • Strumenti di governo dell’impresa
  • Organizzazione e Management:
  • Check Up Organizzativo, Processi, Persone, Competenze
  • Famigliari e Persone chiave, valutazione e supporto (coaching)
  • Sistemi di Reporting ed Informativi
  • Formulazione della strategia, traduzione in azioni e obiettivi, monitoraggio
  • Operazioni straordinarie d’impresa, Fusioni e Acquisizioni, riassetti organizzativi
  • Innovazione Prodotto e Sviluppo Commerciale:
  • Progetti di Innovazione Prodotto
  • Iniziative Commerciali per nuovi Prodotti, Mercati, modelli Distributivi
  • Internazionalizzazione
  • Ricerca e valutazione nuovi Partners
  • Comunicazione, Marketing e Eventi, tradizionale e digitale
  • Corsi Corporate Inglese e MBA a Malta










The golden rules for a compensation system that strikes the fine balance between a startup’s needs and keeping employees happy.

The golden rules for a compensation system that strikes the fine balance between a startup’s needs and keeping employees happy.

“You can’t be transparent if you’re not paying fair, and if you are, there’s no reason to not be transparent.”

“Most startups overpay for talent because they undervalue their own equity — so the candidate will too,”

“You should not lose candidates because another startup at a similar stage is paying them more cash.”


1) No one is ever happy with compensation, and compensation has never made anyone happy

2) People always find out what everyone else is making.

3) Create a system that revisits compensation only 1-2x a year.

4) On the spectrum between formulaic and discretionary compensation, be as formulaic as you can.



Is bitcoin finding its killer app? Falling prices aren’t the real reason to worry about bitcoin

Is bitcoin finding its killer app? Falling prices aren’t the real reason to worry about bitcoin

There are three stories bitcoin’s proponents tell about what bitcoin technology could potentially do for the world: That bitcoin will become a currency used by many people to purchase goods; that it will be a superior method to store value over time; and that it can form the basis of a highly secure and efficient payments system. The volatility of the price chart suggests that storing value, at least so far in its young life, isn’t bitcoin’s strong suit.

And the transaction chart suggests that people aren’t really using bitcoins more often, and efforts to market easy-to-use payments programs to merchants and consumers haven’t meaningfully expanded bitcoin use. If people aren’t using it, and its value is falling, any currency is sunk.

But the real chart that should spell worry for bitcoin investors is this one, which shows that, despite the hurly burly—and more than 100M$ poured into bitcoin start-ups by venture capitalists—actual use of the currency hasn’t really increased. Recent gains in transaction volumes have coincided with a falling price; that is to say, people are selling.