Why Return-on-Equity Often Misleads Investors These Days: Dell Better than Apple?
Return on equity is a time-honored metric designed to measure a company’s ability to turn assets into profits. According to theory, a company with the highest ROE among its peers is most likely to bring the best returns to shareholders. But investors these days should be very skeptical of taking ROE at face value.
But there’s rarely been a time in the past five years that investors were happier holding Dell than Apple. Dell shares are down some 25%, while Apple has risen about 540% with few serious dips along the way.
How can such a key indicator make such a bad call? Return on equity equals net income divided by common shareholder equity. Dell, like so many other companies in recent years, reduced its shareholder equity by buying back its own shares. When that equity goes down, basic math makes ROE goes up, even if management is making mistakes on the ground. Apple had yet to buy back any of its shares, and its number of shares rose. That bigger divisor actually made it harder for it to achieve its outsized ROE.
Share buybacks are one of the most common reasons companies of questionable investment performance show up with the best ROEs. Campbell Soup Co.’s (CPB) near 70% ROE makes it look like one of the best-managed large caps out there, even though its shares still trade well-below their price of five years ago. A big share repurchase program that’s lowered the shares outstanding by about 18% during that period helped the ROE.
Increasing debt, too, can artificially raise ROE. Liabilities are subtracted from assets to get that shareholder equity, so issuing bonds or preferred stock or taking out loans reduces the total.
Conversely, paying off debts makes the ROE look worse. So when solid companies did the responsible thing and paid down debt during the financial meltdown, their ROEs suffered for it. Using the YCharts Stock Screener, looking at companies with market caps of $10 billion and higher, it's easy to see how ROE numbers can be very high even at poorer-performing companies.
There are other factors – asset write-downs, for example – that game ROE numbers, intentionally or not. Usually, investors can take a good ROE seriously at companies that are not in the business of buying back shares or raising cash. But if the share price performance makes that number look too good to be true, it probably is.