What Negative Return on Equity (ROE) Means to Investors

Companies that report losses are more difficult to value than those reporting consistent profits. Any metric that uses net income is nullified as an input when a company reports negative profits. Return on equity (ROE) is one such metric. However, not all companies with negative ROEs are bad investments. 

Key Takeaways

• Return on equity (ROE) is measured as net income divided by shareholders’ equity.
• When a company incurs a loss, the return on equity is negative.
• A negative ROE may occur if a company improves the business, such as through restructuring.
• New businesses, such as startups, typically have many years of losses before becoming profitable.

Components of ROE

• Net income after taxes over a period
• Shareholders’ equity at the start of the period
• Shareholders’ equity at the end of the period

Calculating Return on Equity

In the ROE formula, the numerator is net income or the bottom-line profits reported on a firm’s income statement. The denominator is equity, or, more specifically, shareholders’ equity. When net income is negative, ROE will also be negative.

For most firms, a “good” ROE will depend on the company’s industry and competitors and commonly cover their costs of capital. An industry will likely have a lower average ROE if it is highly competitive and requires substantial assets to generate revenues.

ROE = Net income / Average shareholders’ equity  

A company’s ROE can be analyzed by comparing it to its competitors or how it has changed over time.

Negative ROE Example

When analysts or investors only consider net income, a negative ROE may be misleading. In 2022, Hewlett-Packard (HPQ) reported many charges to restructure its business. The charges included headcount reductions and writing down goodwill after a botched acquisition, resulting in a negative net income of $12.7 billion, or negative $6.41 per share.

Reported ROE was equally dismal at -51%. However, free cash flow generation for the year was positive at $6.9 billion, or $3.48 per share. That’s quite a stark contrast from the net income figure and resulted in a much more favorable ROE level of 30%.

For astute investors, this could have indicated that HP wasn’t in a precarious position as its profit and ROE levels showed. Indeed, the next year net income returned to a positive $5.1 billion, or $2.62 per share. Free cash flow improved as well to $8.4 billion, or $4.31 per share. The stock then rallied as investors started to realize that HP wasn’t as bad an investment as its negative ROE indicated.   

What Can Investors Use to Analyze a Company With Negative Net Income?

A firm may report negative net income, but it doesn’t always mean it is a bad investment. Free cash flow is another form of profitability and can be measured instead of net income.

What If a Company Consistently Loses Money Annually?

Investors should be wary of an organization that consistently loses money without a good reason. In that case, negative returns on shareholders’ equity may be a warning sign that the company is not healthy. For many companies, something as simple as increased competition can deplete returns on equity.

Why Do Startups Commonly Show a Negative ROE?

Initial public offerings (IPOs) or startup companies may lose money in their early days. Therefore, if investors only looked at the negative return on shareholder equity, no one would ever invest in a new business. This type of attitude would prevent investors from buying into great companies early on at relatively low prices. Startups may show negative shareholders’ equity for years, rendering returns on equity meaningless for some time. Even once a company starts making money and pays down accumulated debts on its balance sheet, replacing them with retained earnings, investors can still expect losses.

The Bottom Line

Subscribing to the traditional definition of ROE can mislead investors. Firms that chronically report negative net income, but have healthier free cash flow levels, might translate into a higher ROE than investors might expect. New businesses typically have many years of losses before becoming profitable.