See also: Investment and dividends 126–27 ■ Accountability and governance
130 –31 ■ Who bears the risk? 138–45 ■ Ignoring the herd 146–49
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
- 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.
(%) = Average x 100
Business goals and risks
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.