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You are working as a financial analyst at a brokerage firm and a colleague says to...

You are working as a financial analyst at a brokerage firm and a colleague says to you “the Potts Corporation had a return on equity (ROE) of 20% last year. We should recommend the stock to our clients.” How would you respond to your colleague? (Note: Your response for this question should be no more than 100 words)

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As a financial analyst at a brokerage firm, I would respond to my colleague saying that higher ROE is generally viewed as a positive for a firm but the reason for an increase should be examined. For example, if book value is decreasing more rapidly than net income, ROE will increase. This is not, however, a positive for the firm. A firm can also issue debt to repurchase equity, thereby decreasing the book value of equity. This would increase the ROE but also make the firm's shares riskier due to increased financial leverage (debt).

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