(I orginally posted this article on The DIV-Net website.)
One danger looking solely at ROE is the ability of leverage (debt) to overstate ROE. In 2006, Bear Stearns' ROE was over 19% and this was an increase over the prior years ROE of 16%. What occurs is any debt taken on by a company reduces the equity figure. Since the ROE calculation is essentially net income divided by equity, a higher ROE would result for a company that uses debt versus equity to finance its operations. An example:
If you buy a house for $100,000 and borrow $50,000 to buy it, you have 50 percent debt and 50 percent equity in the home. Say the home is worth $110,000 a year later (this really is a hypothetical situation, isn’t it?). Your ROE is 20 percent: the $10,000 gain is divided by $50,000 in equity.
Now let’s say instead that you borrowed $75,000 to buy the home. The ROE would be 40 percent: $10,000 divided by $25,000 in equity. You’ve taken on more debt, but the results look more impressive.
Additionally, interest on debt (as compared to dividends) receives favorable tax treatment as well. The interest is deducted from a company's income before determining the level of taxes owed. On the other hand, dividends are paid out of net income and a company does not receive a tax deduction for the dividends that are paid. A company can enhance its ROE by using debt so long as the cost of the borrowing is less than the company's ROE.
Another way to calculate ROE is to use the DuPont Model. The DuPont Model formula is:
ROE = Net Profit Margin x Total Asset Turnover x Financial Leverage
- Net Profit Margin = Net Income/Net Sales
- Total Asset Turnover = Net Sales/Total Assets
- Financial Leverage = Total Assets/Total Equity
The DuPont formula enables one to see more directly what is driving the increase in ROE.
Source: Checking for Bloated ROE ($)
By: Michael Maiello