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Author: educatedidiot Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 1933  
Subject: Re: Dumb Question Date: 1/30/2003 4:09 PM
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OK, I know this is probably basic but I have to ask it. How can a company consistantly achieve a ROE significantly higher than the growth of net income?

Just break ROE into its two components: income divided by equity, and the answer becomes more clear. For ROE to exceed net income growth, book value (equity) must shrink without negatively impacting income growth.

Here's two possible scenarios:
1) The company is using all of its earnings to repurchase shares. Cash, and hence equity, will be reduced thus giving an added boost to ROE above and beyond the income growth. [Actually, the funny thing about this scenario is that it doesn't matter how the cash is spent -- the company could literally incinerate all of its excess cash and this would theoretically cause ROE to exceed income growth for the year in which the money is burned.]

2) Company takes on more debt. Again, equity is reduced, but income growth won't decline as a result of having more debt. So again, the leverage provides an added boost to ROE.
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