True Return on Equity is Return on Equity without the effect of financial engineering. Some companies do a lot of stock buybacks to make it appear that their Return on Shareholders' Equity is significantly high. Stock buybacks increase the value of Treasury Stock. In the Balance Sheet, Treasury Stock is a negative number and is deducted from Total Equity. When a company does a lot of stock buybacks, the negative value of Treasury Stock increases and the value of Total Equity decreases.
Return on Equity is Net Income divided by Total Equity. If the value of Total Equity is small because of stock buybacks, the Return on Equity increases to an abnormally high number.
Convert Treasury Stock to a positive number and add it back to Total Equity to calculate the True Return on Equity.
Equations
If the company has Treasury Stock:
Check if True Return on Equity is greater than 20%:
