The Business Book

155

See also: Investment and dividends 126–27 ■ Accountability and governance

130 –31 ■ Who bears the risk? 138–45 ■ Ignoring the herd 146–49

M

any stockmarket analysts

regard “return on equity”

(ROE) as a vital measure

of business success. ROE measures

profit as a percentage of the share-

holder’s equity on the balance sheet.

This “equity” is comprised of share

capital (capital raised from selling

shares) and reserves (the company’s

accumulated, retained profit).

ROE is affected by trading

conditions. Still recovering from

a tsunami and floods, Toyota

achieved an ROE of 3.9 percent in

2012. Rival General Motors (GM),
      unaffected by the natural disasters,
      managed 16.7 percent. Based on
      its ROE, GM appeared to be four to
      five times better at generating profit
      from shareholders’ investment.

A misleading measure

As an indicator of investment

potential, ROE can be problematic.

The percentage outcome is a

function of two things: how high

the profit is, and how low the

shareholders’ equity is. Toyota

and GM both made a similar pretax

profit in 2012, but the amount of

shareholders’ equity in the two

companies creates a misleading

picture. Toyota has a huge balance

sheet with high shareholder equity,

bolstered by decades of high profits.

GM’s bankruptcy in 2009 had

wiped out its reserves, leaving it

with a small equity base. GM’s high

ROE was largely due to its collapse

and US government bailout.

In the 2000s, many banks cut

their balance sheets through “share

buybacks.” Cash was used to buy

shares back from shareholders,

reducing the equity at the bottom

of the formula. This increased the

ROE, but led to a risky capital

structure. By maximizing ROE,

the banks left too little cash to deal

with the 2007–08 financial crash. ■

MAKING MONEY WORK

RETURN ON EQUITY

IS A FINANCIAL GOAL

T H A T C A N B E C O M E

A N O W N G O A L

MAXIMIZE RETURN ON EQUITY

ROE is calculated by dividing profit by

average shareholder equity. The higher

the figure, the more efficient the company

is at generating shareholder returns.

ROE Profit

(%) = Average x 100

shareholder

equity

IN CONTEXT

FOCUS
Business goals and risks

KEY DATES
1978 Legendary investor
Warren Buffett claims that ROE
is not likely to stray from a level
of 12 percent for very long.

1995 : The Warren Buffett Way
by Robert Hagstrom introduces
the public to Buffett’s approach
to investment, including the
importance he places on ROE.

1997 The US’s S&P (Standard
and Poor) index of industrial
companies reveals an average
ROE of 22 percent.

2012 Among international
clothing retailers, ROE varies
from 40 percent at Gap and
39 percent at H&M, to -139
percent at American Apparel.
Based on its ROE alone,
American Apparel should no
longer exist in its current form.