Page 157 - (DK) The Business Book
P. 157
MAKING MONEY WORK 155
RETURN ON EQUITY
IS A FINANCIAL GOAL
THAT CAN BECOME
AN OWN GOAL
MAXIMIZE RETURN ON EQUITY
any stockmarket analysts shareholders’ equity in the two
IN CONTEXT regard “return on equity” companies creates a misleading
M (ROE) as a vital measure picture. Toyota has a huge balance
FOCUS
of business success. ROE measures sheet with high shareholder equity,
Business goals and risks
profit as a percentage of the share- bolstered by decades of high profits.
KEY DATES holder’s equity on the balance sheet. GM’s bankruptcy in 2009 had
1978 Legendary investor This “equity” is comprised of share wiped out its reserves, leaving it
Warren Buffett claims that ROE capital (capital raised from selling with a small equity base. GM’s high
is not likely to stray from a level shares) and reserves (the company’s ROE was largely due to its collapse
of 12 percent for very long. accumulated, retained profit). and US government bailout.
ROE is affected by trading In the 2000s, many banks cut
1995: The Warren Buffett Way conditions. Still recovering from their balance sheets through “share
by Robert Hagstrom introduces a tsunami and floods, Toyota buybacks.” Cash was used to buy
the public to Buffett’s approach achieved an ROE of 3.9 percent in shares back from shareholders,
to investment, including the 2012. Rival General Motors (GM), reducing the equity at the bottom
importance he places on ROE. unaffected by the natural disasters, of the formula. This increased the
managed 16.7 percent. Based on ROE, but led to a risky capital
1997 The US’s S&P (Standard
its ROE, GM appeared to be four to structure. By maximizing ROE,
and Poor) index of industrial
five times better at generating profit the banks left too little cash to deal
companies reveals an average
from shareholders’ investment. with the 2007–08 financial crash. ■
ROE of 22 percent.
2012 Among international A misleading measure
ROE is calculated by dividing profit by
clothing retailers, ROE varies As an indicator of investment average shareholder equity. The higher
from 40 percent at Gap and potential, ROE can be problematic. the figure, the more efficient the company
39 percent at H&M, to -139 The percentage outcome is a is at generating shareholder returns.
percent at American Apparel. function of two things: how high
Based on its ROE alone, the profit is, and how low the ROE Profit x 100
American Apparel should no shareholders’ equity is. Toyota (%) = Average
and GM both made a similar pretax
longer exist in its current form. shareholder
profit in 2012, but the amount of equity
See also: Investment and dividends 126–27 ■ Accountability and governance
130–31 ■ Who bears the risk? 138–45 ■ Ignoring the herd 146–49
