A high ROE may not mean what you think

No single metric can gauge whether a company is a worthy investment. Take return on equity (ROE) , for example. It is the ratio of the company's total profit after tax to the total shareholders' equity (the amount a company owes to its shareholders).

Shareholders use it to assess whether management is efficiently using earnings to grow the business. In simple terms, if ROE is declining, management is making bad investments. Likewise, if ROE is on the rise, management is using its earnings efficiently.

However, like all metrics, ROE has blindspots and is prone to manipulation. Here's how.

It doesn't account for debt. The formula shows that ROE only factors in earnings growth, not how it is achieved. A company might be taking on unsustainable amounts of debt to grow its earnings and pump up its ROE. However, investing in a debt-laden company is highly detrimental to your portfolio. For example, Tata Communications posted an impressive ROE of 137 per cent in FY23. However, a closer look into its books would reveal that this impressive feat came at the cost of a high debt-to-equity of 7.1 times. Its return on capital employed (ROCE), which accounts for debt, was only 28 per cent.

The low-base mirage. Many frequent loss-makers have low shareholders' equity as losses erode away shareholders' wealth. The sudden jump in their earnings, thus, can lead to high ROE and the false assumption that the management has overnight found a magic fix.

For example, CG Power and Industrial Solutions incurred massive losses in FY21, severely impacting its equity base (it turned negative). As a result, when it recorded a Rs 962 crore profit in FY23, its ROE stood at an impressive 71 per cent.

Exceptional gains lead to exceptional ROEs. One-time gains, such as those from selling machinery or other physical assets, can significantly inflate earnings in a given year. Consequently, the ROE also appears optically high for the year, giving the false impression that operational profitability has improved. A case in point is Ramky Infrastructure . It reported a strong ROE of 27 per cent in FY23 due to a one-time exceptional gain of Rs 1295 from extinguishing a debt obligation to a lender.

It is ill-suited for cyclical companies. Cyclical stocks have highly volatile earnings due to the inherent nature of the underlying business. Hence, their ROEs are also highly volatile.

The table below shows the historical ROEs of the cyclical stock, JSW Steel .

Your takeaway
All investment decisions should be made after a comprehensive analysis of the company. Solely basing investment calls on a single metric will more often than not lead to disastrous results. While we used ROE as an example, the same is applicable to all profitability and valuation metrics.