Return on Equity
Return on Equity (ROE) is equal to after – tax income divided by book value. It represents the return on owner’s equity, and is therefore comparable to the accounting measures return on partner’s equity and return on owner’s equity used in the financial analysis of partnerships and sole proprietorships respectively.
Although, in the long – run return on equity is what matters, ROE is often a very poor predictor of future profitability among businesses with different debt loads. Screening for ROE alone tends to unnecessarily penalize small, highly profitable businesses that do not employ debt. You would think the size of the business shouldn’t affect ROE, but it does – indirectly.
Highly profitable, small businesses tend both to be largely owned by management and unable to raise large amounts of debt at low rates despite their levels of free cash flow. For these reasons, they are more likely to favor waiting to finance expansion with cash flow from operations rather than taking on debt that could not be paid off for an extended period.
In the long – run, ROE is an excellent measure of profitability (and managerial performance). In the short run, it can reward companies that take on excessive debt (and will eventually leave their shareholders with nothing). When evaluating a business’ profitability you should always look at all three measures of profitability (ROA, ROC, & ROE).