Question

Below is a list of some of the limitations of ROE:

Suggest a possible way for an analyst to address the limitation (for example, by preparing a sensitivity analysis and evaluating whether the conclusions have changed).

1. One input to ROE is Net Income, which can be distorted by one-time events.

2. If one company reports a net loss (i.e., negative Net Income) and the other reports a profit (i.e., positive Net Income), it isn’t really necessary to compute ROE to know which is more profitable.

3. Another input to ROE is Shareholders’ Equity, which is affected by share buybacks.

4. ROE is purely a financial measure, and operating measures (e.g., same-store sales increase for retailers, revenue per passenger mile for airlines, monthly active users for internet companies) may be more useful.

5. ROE is purely a financial measure and thus essentially ignores how companies affect society.

Answer 1

Return on Equity [ROE]: is the amount of net income returned as a percentage of sharehoder Equity.

ROE = Net Income [Anual]Shareholders Equity

Limitation of ROE:

1) ROE is one of the financial ratio that assests how well entity generate net income over the equity fund that invested by share holders. The ROE calculated on the net income during the period.

• Net income varies greatly from company to company and from industry to industry.
• Net income measured in dollars and companies vary in size, its often more appropriate to consider net income as persentage of sales known as profit margin.

2) Another Situation for which the ROE Produces anamalous resoulst in the startup phase companies with huge future potential may have no or negative net income in the first few years even though they have significant share holder investment. ROE for these companies zero or Even a negative, These does not tell the whole story of the company and minimises its potential down the road.

New capital will take longer to porduce increases in the bottom line, which rises ROE.

3) Stock buy backs can have a drastick effect on ROE

• Companies will regularly engage in Stock buy backs for a number of different reasons. some times, stock buy back from the market can effect Financial ratios such as ROE.
• When a comany buys a larege number of shares from the market, they are going to reduce the share holders equity significantly.
• When the company does this, they are going to also improve the ROE ratio.

4) ROE is purely Financial Measure:

• ROE is a Profitability measure that Equity investores care must about where as Return on assets and return on invested capital each depict a variant of profitability avaliable to both debt and Equity investors.
• ROE stays pure, comparing income avaliable to just equity investores to the capital owned by just Equity Investors.

5) ROE purely financial relation and measures the companies profitabulity and doesnt take importance to measure non financial measures like environment, customer relation and society. Its totally ignores the society and only focused on profitabulity ratio.