PROBLEMS WITH ROE Managers should strive to maximize shareholder wealth.

. If a firm takes steps to improve its ROE, does it mean that shareholder wealth will also increase? Not necessarily, for despite its widespreaduseandthefactthatROEandshareholderwealthare often highly correlated, some problems can arise when firms use ROEasthesolemeasureofperformance. First,ROEdoesnotconsiderrisk.Whileshareholdersclearlycare about returns, they also care about risk. To illustrate this point, consider two divisions within the same firm. Division S has very stablecashflowsandapredictable15percentROE.DivisionR,on theotherhand,hasa16percentexpectedROE,butitscashflows are very risky, so the expected ROE may not materialize. If managerswerecompensatedsolelyonthebasisofROE,andifthe expected ROEswere actually achieved, then Division Rsmanager would receive a higher bonus than Division Ss manager, even thoughDivisionSmayactuallycreatemorevalueforshareholders asaresultofitslowerrisk. Second,ROEdoesnotconsidertheamountofinvestedcapital.To illustrate this point, lets consider a rather extreme example. A largecompanyhas$1investedinProjectA,whichhasanROEof50 percent, and $1 million invested in Project B, which has a 40 percent ROE. The projects are equally risky, and the two returns arebothwellabovethecostthecompanyhadtopayforthecapital invested in the projects. In this example, Project A has a higher ROE,butsinceitissosmall,itdoeslittletoenhanceshareholder wealth. Project B, on the other hand, has the lower ROE, but it addsmuchmoretoshareholdervalue.

Consider one last problem with ROE. Assume that you manage a divisionofalargefirm.ThefirmusesROEasthesolemeasureof performance, and it determines bonuses on the basis of ROE. Toward the end of the fiscal year, your divisions ROE is an impressive45percent.Nowyouhaveanopportunitytoinvestina large, lowrisk project that has an estimated ROE of 35 percent, which is well above the cost of the capital you need to make the investment. Even though this project is profitable, you might be reluctant to make the investment because it would reduce your divisions averageROE,andthereforereducethesizeofyouryearendbonus. These three examples suggest that a projects return must be combined with its risk and size to determine its effect on shareholdervalue.TotheextentthatROEfocusesonlyonrateof return, increasing ROE may in some cases be inconsistent with increasing shareholder wealth. With this in mind, academics, practitioners, and consultants have tried to develop alternative measuresthatovercomeROEspotentialproblemswhenitisused asthesolegaugeofperformance.