BUSINESS

Reviewed by Charlene Rhinehart
Fact checked by Suzanne Kvilhaug

Companies that report losses are more difficult to value than those reporting consistent profits. Any metric that uses net income is nullified as an input when a company reports negative profits. Return on equity (ROE) is one such metric. However, not all companies with negative ROEs are bad investments. 

Key Takeaways

• Return on equity (ROE) is measured as net income divided by shareholders’ equity.
• When a company incurs a loss, the return on equity is negative.
• A negative ROE may occur if a company improves the business, such as through restructuring.
• New businesses, such as startups, typically have many years of losses before becoming profitable.

Components of ROE

• Net income after taxes over a period
• Shareholders’ equity at the start of the period
• Shareholders’ equity at the end of the period

Calculating Return on Equity

In the ROE formula, the numerator is net income or the bottom-line profits reported on a firm’s income statement. The denominator is equity, or, more specifically, shareholders’ equity. When net income is negative, ROE will also be negative.

For most firms, a “good” ROE will depend on the company’s industry and competitors and commonly cover their costs of capital. An industry will likely have a lower average ROE if it is highly competitive and requires substantial assets to generate revenues.

ROE = Net income / Average shareholders’ equity  

A company’s ROE can be analyzed by comparing it to its competitors or how it has changed over time.

Negative ROE Example

When analysts or investors only consider net income, a negative ROE may be misleading. In 2022, Hewlett-Packard (HPQ) reported many charges to restructure its business. The charges included headcount reductions and writing down goodwill after a botched acquisition, resulting in a negative net income of $12.7 billion, or negative $6.41 per share.

Reported ROE was equally dismal at -51%. However, free cash flow generation for the year was positive at $6.9 billion, or $3.48 per share. That’s quite a stark contrast from the net income figure and resulted in a much more favorable ROE level of 30%.

For astute investors, this could have indicated that HP wasn’t in a precarious position as its profit and ROE levels showed. Indeed, the next year net income returned to a positive $5.1 billion, or $2.62 per share. Free cash flow improved as well to $8.4 billion, or $4.31 per share. The stock then rallied as investors started to realize that HP wasn’t as bad an investment as its negative ROE indicated.   

What Can Investors Use to Analyze a Company With Negative Net Income?

A firm may report negative net income, but it doesn’t always mean it is a bad investment. Free cash flow is another form of profitability and can be measured instead of net income.

What If a Company Consistently Loses Money Annually?

Investors should be wary of an organization that consistently loses money without a good reason. In that case, negative returns on shareholders’ equity may be a warning sign that the company is not healthy. For many companies, something as simple as increased competition can deplete returns on equity.

Why Do Startups Commonly Show a Negative ROE?

Initial public offerings (IPOs) or startup companies may lose money in their early days. Therefore, if investors only looked at the negative return on shareholder equity, no one would ever invest in a new business. This type of attitude would prevent investors from buying into great companies early on at relatively low prices. Startups may show negative shareholders’ equity for years, rendering returns on equity meaningless for some time. Even once a company starts making money and pays down accumulated debts on its balance sheet, replacing them with retained earnings, investors can still expect losses.

The Bottom Line

Subscribing to the traditional definition of ROE can mislead investors. Firms that chronically report negative net income, but have healthier free cash flow levels, might translate into a higher ROE than investors might expect. New businesses typically have many years of losses before becoming profitable.

Reviewed by Amy Drury

What Is Compound Interest

Compound interest is interest that’s calculated both on the initial principal of a deposit or loan, and on all accumulated interest.

Compound interest is a tremendous advantage for savers and investors. For borrowers, not so much. That’s because savers and investors benefit from the powerful growth in the value of their financial accounts that compounding interest provides over time.

For borrowers, that compounding interest and growth in balance benefits the lender and means having to pay more to get out of debt.

Read on to learn more about compound interest and how to calculate it using Excel.

Key Takeaways

• Compound interest is calculated on the amounts of principal (or initial deposit) and interest in your account.
• As interest increases your account value, subsequent compound interest calculations apply to larger amounts.
• Compound interest can be an advantage if you’re saving money or a disadvantage if you’re borrowing it.
• Excel can simplify your compound interest calculations.

Understanding Compound Interest

Compound Interest Works In Your Favor

Let’s say that you have an account with a deposit of $100 that earns a 10% annual compounded interest rate. That $100 grows to $110 after the first year:

$100 x .10 = $10

$100 + $10 = $110 new balance

The account value then grows to $121 when interest is calculated after the second year. 

$110 x .10 = $11

$110 + $11 = $121 new balance

The reason the second year’s gain is $11 instead of $10 is because the 10% rate was applied to a larger account balance.

As you can see, the 10% interest applied to $100 created the new balance of $110. After year two, the 10% was applied to that new balance of $110, for a third new balance $121. At the end of the third year, the 10% will be applied to $121 and a larger new balance will be the result.

Because compound interest is working for you by increasing the value of your investment, you’ll want to keep your money invested for as long as possible.

Compound Interest Works Against You

Let’s say that you borrowed $100 (the principal amount) at a compound interest rate of 10% that’s applied annually. Using the same calculation above, after one year you’ll have $100 in principal and $10 in interest, for a total amount owed by you of $110. 

$100 x .10 = $10

$100 + $10 = $110 new balance

In year two, the 10% interest rate is applied to both the principal of $100, resulting in $10 of interest, and the accumulated interest of $10, resulting in $1 of interest. This results in a total of $11 in interest gained that year, which is $21 for both years ($10 after year one + $11 after year two).

$100 x .10 = $10

$10 x .10 = $1

$10 + $1 = $11 total new interest

$110 + $11 = $121 new balance 

Because compound interest is working against you by increasing the amount you must pay back to the lender, you’ll want to pay off your debt as soon as possible.

Formula for Compound Interest

The compound interest formula is similar to the Compounded Annual Growth Rate (CAGR). For CAGR, you are computing a rate that links the return over a number of periods. For compound interest, you most likely know the rate already and are just calculating what the future value of the return might be. 

For the formula for compound interest, just algebraically rearrange the formula for CAGR. You need the:

• Beginning value
• Interest rate
• Number of periods in years

The interest rate and number of periods need to be expressed in annual terms, since the length is presumed to be in years. From there you can solve for the future value. The equation reads:

$begin{aligned}&text{Beginning Value}\&timesleft(1+left(frac{text{interest rate}}{text{NCPPY}}right)right)^{(text{years} times text{NCPPY)} = text{Future Value}}\&textbf{where:}\&NCPPY=text{number of compounding periods per year}end{aligned}$​Beginning Value×(1+(NCPPYinterest rate​))(years × NCPPY) = Future Valuewhere:NCPPY=number of compounding periods per year​

This formula looks more complex than it really is, because of the requirement to express it in annual terms. 

Keep in mind, if it’s an annual rate, then the number of compounding periods per year is one, which means you’re dividing the interest rate by one and multiplying the years by one. If compounding occurs quarterly, you would divide the rate by four, and multiply the years by four. 

Calculating Compound Interest in Excel

Financial modeling best practices require calculations to be transparent and easily auditable. The trouble with piling all of the calculations into a formula is that you can’t easily see what numbers go where, or what numbers are user inputs or hard-coded. 

There are three ways to set this up in Excel. The most easy to audit and understand is to have all the data in one table, then break out the calculations line by line. Conversely, you could calculate the whole equation in one cell to arrive at just the final value figure. All three ways are detailed below:

Does Interest Always Compound Annually?

No, it can compound at other intervals including monthly, quarterly, and semi-annually. Some investment accounts, such as money market accounts, compound interest daily and report it monthly. The more frequent the interest calculation, the greater amount of money that results.

Why Does Compound Interest Matter?

It matters because it can increase financial values for account balances more quickly than simple interest. These increasing balances may be great for savers and investors who want to see their money grow. But for borrowers, they can be a source of worry and financial hardship if they aren’t able to pay them down or completely off as quickly as they can.

Who Sets the Compound Interest?

That can depend. A financial institution will set the rate and interval for different accounts that it offers savers, investors, and borrowers. If you’re lending money to a friend for a business opportunity, you might set a compound interest rate that will be charged annually (or more frequently) until the loan is repaid.

The Bottom Line

Excel can be a helpful and powerful partner when you need to calculate compound interest amounts for different purposes, such as loans and investments. It’s especially convenient when frequent intervals are involved over multiple years and accuracy counts.

How the Oracle of Omaha Profits When Others Panic

Since 1965, shares of Warren Buffett’s conglomerate, Berkshire Hathaway (BRK.B), have delivered a compounded annual return of 19.9%—almost double that of the S&P 500 over the same period. Unlike many of Wall Street’s famous money managers, Buffett has thrived during market crashes by following a straightforward approach any investor can follow: buying quality businesses at discounted prices when others are selling in a panic.

Below, we break down the principles that have kept Buffett successful through several market crashes.

What You Need to Know

• Buffett turns market crashes into opportunities by following his own advice to “be fearful when others are greedy and greedy when others are fearful.”
• Focusing on strong business fundamentals rather than short-term price movements has been central to Buffett’s success, as demonstrated by his long-term holdings in companies like Coca-Cola Co. (KO) and American Express Company (AXP).

Principle 1: Stay Calm and Avoid Panic Selling

Buffett often emphasizes that “the stock market is designed to transfer money from the
active to the patient.” He cautions against emotional decision-making during market downturns, noting that selling out of fear often leads to significant losses.

A look at the S&P 500 Index’s long-term performance proves his point—despite countless sell-offs, recessions, and geopolitical crises, $100 invested in 1928 would be worth over $982k today.

Principle 2:

Among Buffett’s best-known and most-repeated quotes is, “Be fearful when others are greedy and be greedy only when others are fearful.” This isn’t just clever wordplay—it’s the backbone of his wealth-building strategy.

While most investors run for the exits during market crashes, Buffett reaches for his checkbook. During the 2008 financial crisis, when banking stocks were in free fall and many predicted the collapse of the financial system, Buffett invested $5 billion in Goldman Sachs Group, Inc. (GS). The deal included preferred shares with a 10% dividend yield and warrants to purchase common stock, ultimately netting Berkshire Hathaway over $3 billion in profit.

Principle 3: Focus on Business Fundamentals

Buffett has a simple test for market downturns: Does a 30% drop in share price change how many Cokes people will drink next year? Does it affect how many people will use their American Express cards? If the answer is no, then the intrinsic value remains intact despite the market’s temporary opinion.

Berkshire Hathaway’s investment in the Washington Post illustrates this approach. In 1973, during a severe market decline, Buffett purchased shares at just 25% of what he calculated as their intrinsic value. The price fell even further afterward, but Buffett wasn’t deterred—he understood the fundamental strength of the business wasn’t reflected in its stock price. His patience paid off: Berkshire’s $10.6 million investment ballooned to over $200 million by 1985, a return of almost 1,900%. This wasn’t investment wizardry—it was Buffett recognizing that fearful markets often misprice great businesses. 

Principle 4: Don’t Time the Market

Buffett discourages trying to predict market movements, calling it a fool’s game, and instead holds for the (very) long term. Once again putting his money where his mouth is, Buffett has held shares of
Coca-Cola for 36 years and has held American Express shares since the 1960s.

Principle 5: Keep Cash Reserves for Opportunities

While most financial advisors recommend staying fully invested, Buffett views cash differently—not as something that doesn’t earn interest or dividends sitting in a bank account, but as “financial ammunition” for when rare prospects appear.

Berkshire’s massive cash position—often criticized during bull markets—transforms from a liability into Buffett’s secret weapon during crashes. In 2010, after deploying billions during the financial crisis, Buffett formalized this strategy in his shareholder letter, pledging to maintain at least $10 billion in cash reserves (though typically keeping closer to $20 billion). This wasn’t excessive caution but strategic preparation for the next inevitable market panic.

In the mid-2020s, with the markets on edge, Buffett is again holding a record cash stockpile.

The Bottom Line

Buffett’s philosophy underscores the importance of staying rational, focusing on fundamentals, and seeing market declines as opportunities rather than setbacks.

Here are the types of stocks that typically do well—and the types that typically don’t—during market downturns

Reviewed by Michael J Boyle
Fact checked by Timothy Li

During a recession, the worst-performing assets are highly leveraged, cyclical, and speculative. Companies that fall into any of these categories can be risky for investors because of the potential that they could go bankrupt.

Conversely, investors who want to thrive during a recession will invest in high-quality companies that have strong balance sheets, low debt, and good cash flow, and are in industries that historically do well during tough economic times.

Key Takeaways

• During a recession, most investors should avoid investing in companies that are highly leveraged, cyclical, or speculative, as these companies pose the biggest risk of doing poorly during tough economic times.
• A better recession strategy is to invest in well-managed companies that have low debt, good cash flow, and strong balance sheets.
• Countercyclical stocks do well in a recession and experience price appreciation despite the prevailing economic headwinds.
• Some industries are considered more recession-resistant than others, such as utilities, consumer staples, and discount retailers.

Types of Stocks with the Biggest Recession Risk

Knowing which assets to avoid investing in can be just as important as knowing which companies make good investments. The companies and assets with the biggest risk during a recession are those that are highly leveraged, cyclical, or speculative.

Highly Leveraged Companies

During a recession, most investors would be wise to avoid highly leveraged companies that have huge debt loads on their balance sheets. These companies often suffer under the burden of higher-than-average interest payments that lead to an unsustainable debt-to-equity (DE) ratio.

While these companies struggle to make their debt payments, they are also faced with a decrease in revenue brought about by the recession. The likelihood of bankruptcy (or at the very least a precipitous drop in shareholder value) is higher for such companies than those with lower debt loads.

Credit Crunch

The more leveraged a company is, the more vulnerable it can be to tightening credit conditions when a recession hits.

Cyclical Stocks

Cyclical stocks are often tied to employment and consumer confidence, which often decline in a recession. Cyclical stocks tend to do well during boom times, when consumers have more discretionary income to spend on nonessential or luxury items. Examples would be companies that manufacture high-end cars, furniture, or clothing.

When the economy falters, however, consumers typically cut back their spending on these discretionary expenses. They reduce spending on things like travel, restaurants, and leisure services. Because of this, cyclical stocks in these industries tend to suffer, making them less attractive investments for investors during a recession.

Cyclical Assets

Stocks that move in the same direction as the underlying economy are at risk when the economy turns down.

Speculative Stocks

Speculative stocks are valued based on optimism among the shareholder base. This optimism is tested during recessions, and these assets are typically the worst performers in a recession.

Speculative stocks have not yet proven their value and are often seen as under-the-radar opportunities by investors looking to get in on the ground floor of the next big investment opportunity. These high-risk stocks often fall the fastest during a recession as investors pull their money from the market and rush toward safe-haven investments that limit their exposure during market turbulence.

Speculation

Speculative asset prices are often fueled by the market bubbles that form during an economic boom—and go bust when the bubbles pop.

Types of Stocks that Often Do Well During Recessions

While it might be tempting to ride out a recession with no exposure to stocks, investors may find themselves missing out on significant opportunities if they do so. Historically, there are companies that do well during economic downturns. Investors might consider developing a strategy based on countercyclical stocks with strong balance sheets in recession-resistant industries.

Strong Balance Sheets

A good investment strategy during a recession is to look for companies that are maintaining strong balance sheets or steady business models despite the economic headwinds. Some examples of these types of companies include utilities, basic consumer goods conglomerates, and defense stocks. In anticipation of weakening economic conditions, investors often add exposure to these groups in their portfolios.

By studying a company’s financial reports, you can determine if they have low debt, healthy cash flows, and are generating a profit. These are all factors to consider before making an investment.

Strong Balance Sheets

Companies with strong balance sheets are less vulnerable to tightening credit conditions and have an easier time managing the debt that they do have.

Recession-Resistant Industries

While it might seem surprising, some industries perform quite well during recessions. Investors looking for an investment strategy during market downturns often add stocks from some of these recession-resistant industries to their portfolios.

Countercyclical stocks like these tend to do well during recessions because their demand tends to increase when incomes fall or when economic uncertainty prevails. The stock price for countercyclical stocks generally moves in the opposite direction of the prevailing economic trend. During a recession, these stocks increase in value. During an expansion, they decrease.

These outperformers generally include companies in the following industries: consumer staples, grocery stores, discount stores, firearm and ammunition makers, alcohol manufacturers, cosmetics, and funeral services.

Consumer Demand

Many of these companies see an increase in demand when consumers cut back on more expensive goods or brands or seek relief and security from fear and uncertainty.

Investing During the Recovery

Once the economy is moving from a recession to a recovery, investors should adjust their strategies. This environment is marked by low interest rates and rising growth.

The best performers are those highly leveraged, cyclical, and speculative companies that survived the recession. As economic conditions normalize, they are the first to bounce back and benefit from increasing enthusiasm and optimism as the recovery takes hold. Countercyclical stocks tend not to do well in this environment. Instead, they encounter selling pressure as investors move into more growth-oriented assets.

Risky, leveraged, speculative investments benefit from the rise in investor sentiment and the easy money conditions that characterize the boom phase of the economy.

Is It Risky to Invest When a Recession is Nearing?

When an economy is nearing a recession, chances are that markets will fall as profits shrink and growth turns negative. During a recession, stock investors must use extra caution, as there is a good chance that they will see price depreciation of their investments. That said, timing a recession is difficult to do, and selling into a falling market may be a bad choice. Most experts agree that one should stay the course and maintain a long-term outlook even in the face of a recession, and use it as an opportunity to buy stocks on sale.

Which Assets Tend to Fare Best in a Recession?

Not all assets are impacted the same way by a recession. As spending shifts to basics, consumer staples, utilities, and other defensive stocks may fare better. Companies with strong balance sheets will also be able to weather a temporary decline in profits more than a high-spending growth stock. Outside of stocks, bonds may rise and interest rates are cut in response to an economic contraction.

Which Stocks Are Hurt the Most by a Recession?

Growth stocks with high debt loads are often the most vulnerable to a recession. This is because they may find it hard to raise new capital as the economy contracts, while their profits can be eroded by lower consumer spending. Speculative stocks with shaky fundamentals are among the most risky as a recession hits.

The Bottom Line

Every recession eventually turns around and goes up over the long run. By developing a strategy based on countercyclical stocks with strong balance sheets in recession-resistant industries, investors can get in on one of the biggest market booms and avoid the turbulence that often results when the economy weakens.

Long-term investors willing to stand through these volatile times eventually will be able to reap the rewards. They may also be able to sell quickly and buy more profitable assets when the bear market is in full force and position themselves ahead of the recovery for even bigger gains when the market improves.