Return On Equity
(RoE)

Determining the accounting value. Explanation of Return On Equity.

What is Return On Equity? Description

ROE is an accounting valuation method similar to Return on Investment (ROI). Return on Equity (ROE) is one measure of how efficiently a company uses its assets to produce earnings.

Return on Equity Because the numerator (Net Income) is an unreliable corporate performance measurement, the outcome of the formula for ROE must also be unreliable to determine success or corporate value.

However the formula still shows up in many annual reports.

Return on Equity overstates economic value

The degree to which ROE overstates the economic value depends on at least 5 factors.

Length of project life. If this is longer, the overstatement will be bigger.
Capitalization policy. If the fraction of total investment capitalized in the books is smaller, the overstatement will be bigger.
Rate at which depreciation is taken in the books. Depreciation rates that are faster than straight-line basis will result in a higher ROE.
Lag between investment outlays and earning back these outlays from cash inflows. If the time lag is greater, the degree of overstatement will also be greater.
Growth rate of new investment. Fast growing companies will have lower Return On Equity.

On top of this, ROE is sensitive to leverage: because it assumes that proceeds from debt financing can be invested at a return greater than the borrowing rate, the ROE will increase with greater amounts of leverage.