Problems with Relying Solely on ROE

The problem with looking at high rates of return on shareholders' equity is that some businesses have purposely shrunk their equity base with large dividend payments or share repurchase programs. They do this because increasing the return on shareholders' equity makes the company's stock more enticing to investors.

Thus, you will find companies in a price-competitive business, like General Motors, reporting high rates of return on shareholders' equity. To solve this problem, you must look at the return on total capital to help screen out these types of companies.

Return on total capital is defined as the net earnings of the business, minus dividends, divided by the total capital in the business. Like this,

ROTC = (Net Income - Dividends) / Total Capital

Look for a consistently high rate of return on total capital AND a consistently high rate of return on equity.