Investors seek out opportunities in the market with the intention of securing a return, at least in the long-term. As a result, the return on equity ratio is usually carefully monitored by diligent investors, and most try to avoid opportunities where their return would be negative. Investors can help protect themselves from losses by learning about the causes of a negative return and the risks or opportunities it may present.
Basics of Return on Equity
Shareholder's equity is the term investors use for all of the money that a business owes to its owners – the total amount invested in the business. Return on equity is a calculation that investors use to assess the performance of this investment.
Return on equity is figured by taking the company's net earnings – remaining revenues after subtracting expenses – as a percentage of the total amount invested in the company. For example, a company that has a total equity investment of $100,000 and net earnings of $8,000 would post an eight percent return on equity.
Negative Return on Equity
When a business's return on equity is negative, it means its shareholders are losing, rather than gaining, value. This is usually a very bad sign for investors and managers try to avoid a negative return as aggressively as possible.
Most investors avoid placing their money in a company that fails to consistently deliver positive returns, but investors may overlook a negative return for a single tough year if they believe the company is well-positioned for long-term growth.
Read More: The Advantages of Return on Equity
Negative ROE Interpretation
While a negative return is rarely desired, it's sometimes important to determine the causes of a negative return if possible. Most companies actually post a negative return in their early years, due mainly to the significant costs of start-ups, including capital expenditures – investments in equipment and other major assets.
Economic downturns and recessions can temper demand from a company's customers, and even well-managed companies might post negative returns on equity if the larger economy is in trouble.
To understand the effect of larger economic trends on a company's equity, it is important to compare their performance with that of similar companies.
Implications for Managers and Investors
Depending on the underlying causes of a negative return, poor performance may be an indicator of inefficient management or an ineffective business model. Looking at long-term performance trends – whether the company has consistently grown its return on equity, or if it has decreased it over time – can help to determine long-term growth potential.
In some cases, a company with a negative return could be a good opportunity, if other aspects of its financial situation show the prospect of longer-term growth.
Finally, a negative return is usually reflected in a company's stock price, as there is less demand for shares of a company that cannot generate a positive return.
Read More: Why Do Stock Prices Drop?
Matt Petryni has been writing since 2007. He was the environmental issues columnist at the "Oregon Daily Emerald" and has experience in environmental and land-use planning. Petryni holds a Bachelor of Science of planning, public policy and management from the University of Oregon.