Why can't ROE Return on Equity of companies we invest in be 100% or 200% but usually less than 40%?

Question

This question is about to analyze the financials of a company we invest in:
Shareholder's Equity is defined by Asset - Liability.  Let's say if the company is started with $100 million, and it earns $0 million.  Now the bank loaned the company $100 million (maybe because the company has a patent), but then the company spent about $100 million as expenses over 3 years to attract businesses.
After 3 years, the company earns $10 million, and the asset is $100 million, and liability is $100 million, then isn't it true that the ROE is infinite or (or even minus infinite?). If the asset is $101 million and liability is $100 million, then ROE is $10 million / $1 million = 1000%, and if the asset is $99 million and the liability is $100 million, then the ROE is $10 million / (-$1 million) = -1000%.  But we almost never see ROE greater than 100% or negative, but usually is seen as 40% at most and is considered to be spectacular. Why isn't ROE much larger such as 100% or 300% or negative?

D Stanley · Accepted Answer

You have a faulty premise.
Yahoo Screener lists 331 stocks (with some duplication due to different share classes and locations) with an ROE of over 1,000%, and 2,184 with a ROE of over 100%. So it's not true that you "never" see a company with an ROE this high.
That said, it's unusual for a healthy, mature company to have such a large ROE. Companies with abnormally high ROE likely have it because their equity is incredibly low due to high debt, as in your example. So a high ROE by itself is not necessarily a great indicator - it has to be looked at in context with other indicators (like D/E ratio).
Also, you almost never see a "negative" ROE - you generally see an N/A or some other indicator if equity is zero or negative. A negative ROE is meaningless because the negative could come from the equity side or the earnings side. You also never see an ROE for a company with negative equity for the same reason (what if a company had negative equity and a loss? Would you expect a positive ROE?)

Why can't ROE Return on Equity of companies we invest in be 100% or 200% but usually less than 40%?

One Answer

Add your own answers!

Ask a Question