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 2

This article was originally published on November 14, 2023.