Wednesday, October 24, 2007

Biased Return On Equity (ROE)

In our previous blog, we have discussed the power of ROE which is a good measurement of efficiency of management in utilization of shareholders' equity. By comparing the ROE of different companies, we can observe which company is managed with better effeciency. However, sometimes ROE can be biased such that the actual situation may not be truly reflected. We have to look into the details to see whether the figure is reasonable.

One example is China Construction Bank (939). In its latest interim report 2007, it states that its annualised ROE have increased from 15.67% to 20.88% which is a significantly improvement. From this figure, it may be good to see that the management has hugely improved its efficiency. However, when you look into details of the ROE (ROE=Return/Shareholders' Equity x 100%), you will find that the great improvement is partially because the Shareholder's Equity has decreased. Shareholder's Equity has decreased by 1.35% from RMB330204Mill at 31th Dec 2006 to RMB325,738Mill at 30th Jun 2007. Obviously, this will not be a good news to the shareholders. An increase in shareholder's equity will be more favorable to shareholders.
From the above, you can see that simply comparing figures is not enough in drawing conclusions about a company. Devils may lie within the details.

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