One
key difference between this measure and the
return on invested capital is that cash is
not netted out; interest income from cash
is part of net income and the book value of
equity incorporates the cash holdings of the
firm. The return on equity for a company is
therefore a composite return on all of its
assets - cash and operating. To the extent
that cash is very different, both in terms
of risk and return, from operating assets,
the return on equity for firms with significant
cash balances will be depressed by the low
and riskless returns earned by cash. To get
a cleaner measure of returns on equity invested
just in operating assets, the return on equity
computation can be modified as follows:
Which
one you use will depend in large part on what
you compare it to. If you are computing a
return on equity to compare to the cost of
equity for a firm, where the cost of equity
reflects all assets owned by the firm, the
conventional measure of ROE will suffice.7
If the cost of equity is computed based on
the riskiness of only the operating assets
of the firm, the non-cash ROE is the better
measure of returns.
There
is one final complexity that sometimes arises
with the use of book value of equity. While
invested capital is almost always a positive
number, there are a significant number of
firms with negative book values for equity.8
When this occurs, the return on equity becomes
a meaningless number and you may have to revert
back to a return on invested capital.
Other
Measures
There
are other measures of accounting returns but
most of them suffer from inconsistency problems
that make them useless from the perspective
of valuation and corporate finance. For instance,
there are variations of return on capital
where analysts use net income instead of after-tax
operating income in the numerator. Dividing
the net income by the book value of all capital
will give you a misleadingly low return for
any firm that has substantial debt and will
tell you little about the quality of its investments.
7If
the cost of equity is computed using a CAPM
beta, this will be the case if you use a regression
beta (since historical stock returns are affected
by cash holdings) or if you use an unlevered
beta that incorporates cash. In other words,
if you have a steel company that is 20% cash,
the unlevered beta you will use will be a
weighted average of the beta of steel and
the beta of cash, with the weights being 80%
and 20%.
8
The book value of equity is adjusted to reflect
retained earnings. Firms that report years
of large losses can end up with negative book
value of equity.
Return to document index
