Return on equity is net income divided by shareholder equity over some measurement period. As such, this measure will have all of the potential problems of net income, plus the pitfalls associated with other return measures. These problems can undermine the degree to which higher returns denote greater value.
Beyond these potential issues, return on equity is affected by the firm's debt as a percent of its total capital, i.e., its leverage. All things being equal, higher leverage would increase ROE, regardless of the value impact of such leverage.
What Return on Equity misses
If a mature company wants to fund a new investment, it generally has a choice of using cash derived from prior earnings or cash raised by borrowing. All else being equal, financing the investment with new debt would increase ROE. In fact, an investment funded entirely with debt that had any returns (e.g., new operating margin greater than the new interest costs) will show an increase in ROE. In other words, a debt-funded investment with a return greater than the cost of debt, but less than the cost of equity, will increase ROE even though it is likely destroying value.
A company can also borrow money to buy back shares as a way to bump up ROE. ROE may go up significantly even if the sole effect on the company is new interest expense from the borrowing. To the extent that this moves the company toward an optimal capital structure for the company, or it signals a more conservative use of cash when that is an appropriate strategy, such a transaction may be value creating. Otherwise, it may simply be incurring additional costs while bumping up ROE.
When it works
As with return measures in general, if you happen to be operating a business where you have a fixed pool of capital, and one chance to invest it, return on equity will reliably track value creation. Business models with those characteristics include closed-end funds or family offices.
