Chapter 4 Analysis of Financial Statements 109S has stable cash " ows and a predictable 15% ROE. Division R has a 16% expected
ROE, but its cash " ows are quite risky; so the expected ROE may not materialize.
If managers were compensated solely on the basis of ROE and if the expected
ROEs were actually achieved during the coming year, Division R’s manager would
receive a higher bonus than S’s even though S might actually be creating more
value for shareholders as a result of its lower risk. Similarly,! nancial leverage can
increase expected ROE, but more leverage means higher risk; so raising ROE
through the use of leverage may not be good.
Second, ROE does not consider the amount of invested capital. To illustrate,
consider a company that is choosing between two mutually exclusive projects. Proj-
ect A calls for investing $50,000 at an expected ROE of 50%, while Project B calls for
investing $1,000,000 at a 45% ROE. The projects are equally risky, and the compa-
ny’s cost of capital is 10%. Project A has the higher ROE, but it is much smaller.
Project B should be chosen because it would add more to shareholder wealth.
Third, a focus on ROE can cause managers to turn down pro! table projects.
For example, suppose you manage a division of a large! rm and the! rm deter-
mines bonuses solely on the basis of ROE. You project that your division’s ROE for
the year will be an impressive 45%. Now you have an opportunity to invest in a
large, low-risk project with an estimated ROE of 35%, which is well above the
! rm’s 10% cost of capital. Even though this project is extremely pro! table, you
might still be reluctant to undertake it because it would reduce your division’s av-
erage ROE and therefore your year-end bonus.
These three examples suggest that a project’s ROE must be combined with its
size and risk to determine its effect on the! rm’s stock price:
Contribution of a project to stock price! f(ROE, Risk, Size)
We will discuss this in more depth when we consider capital budgeting, where we
look in detail at how projects are selected so as to maximize stock prices.
4-14 LOOKING BEYOND THE NUMBERS
Working through this chapter should increase your ability to understand and
interpret! nancial statements. This is critically important for anyone making busi-
ness decisions or forecasting stock prices. However, sound! nancial analysis
involves more than just numbers—good analysis requires that certain qualitative
factors also be considered. These factors, as summarized by the American Associa-
tion of Individual Investors (AAII), include the following:
- Are the company’s revenues tied to one key customer? If so, the company’s
performance may decline dramatically if that customer goes elsewhere. On
the other hand, if the customer has no alternative to the company’s products,
this might actually stabilize sales. - To what extent are the company’s revenues tied to one key product? Firms that
focus on a single product are often ef! cient, but a lack of diversi! cation also
Students might want to refer
to AAII’s educational
web site at http://www.aaii.
com. The site provides
information on investing
basics, financial planning,
portfolio management, and
the like, so that individuals
can manage their own assets
more effectively.SELF^ TEST If a! rm takes steps that increase its expected future ROE, does this necessar-
ily mean that the stock price will also increase? Explain.