Return on Equity (ROE) is one of the most important metrics for evaluating a company's profitability. It tells you how efficiently a company uses shareholder capital to generate profits. Warren Buffett considers ROE one of the key indicators of a quality business. This guide will teach you everything you need to know about ROE.
What is Return on Equity?
Return on Equity measures how much profit a company generates for every dollar of shareholder equity. It answers the question: how effectively is management using the money shareholders have invested?
The Formula: ROE = Net Income / Shareholders Equity. An ROE of 15% means the company generates $0.15 of profit for every $1 of shareholder equity.
How to Calculate ROE
You need two numbers from the financial statements:
- Net Income: From the income statement (bottom line profit)
- Shareholders Equity: From the balance sheet (total assets minus total liabilities)
Example Calculation
Company XYZ reports:
- Net Income: $50 million
- Shareholders Equity: $250 million
- ROE: 20% ($50M / $250M)
This means the company generated a 20% return on shareholder investment.
What is a Good ROE?
The answer depends on the industry, but here are general guidelines:
Below 10%
Generally considered weak. The company may not be using capital efficiently or may have structural problems.
10% to 15%
Average performance. Acceptable for capital-intensive industries like utilities or manufacturing.
15% to 20%
Good performance. Indicates effective management and solid competitive position.
Above 20%
Excellent performance. Often indicates a competitive advantage or efficient business model. However, investigate whether high ROE is driven by excessive leverage.
Typical ROE by Industry
- Technology: 15% to 30% (high margins, low capital needs)
- Financial Services: 10% to 15% (leverage-dependent)
- Consumer Goods: 15% to 25% (brand power)
- Utilities: 8% to 12% (capital intensive, regulated)
- Healthcare: 12% to 20% (varies by segment)
The DuPont Analysis: Breaking Down ROE
The DuPont analysis decomposes ROE into three components to understand what drives it:
ROE = Profit Margin x Asset Turnover x Financial Leverage
1. Profit Margin (Net Income / Revenue)
Measures how much of each dollar of sales turns into profit. Higher is better.
2. Asset Turnover (Revenue / Total Assets)
Measures how efficiently assets generate sales. Higher means better asset utilization.
3. Financial Leverage (Total Assets / Shareholders Equity)
Measures how much debt the company uses. Higher leverage amplifies ROE but also increases risk.
DuPont Analysis Example
Two companies both have 18% ROE but achieve it differently:
Company A (High Margin):
- Profit Margin: 15%
- Asset Turnover: 0.8
- Leverage: 1.5
- ROE: 15% x 0.8 x 1.5 = 18%
Company B (High Leverage):
- Profit Margin: 6%
- Asset Turnover: 1.0
- Leverage: 3.0
- ROE: 6% x 1.0 x 3.0 = 18%
Company A's ROE is higher quality because it comes from profitability, not debt.
Why High ROE Can Be Misleading
A high ROE is not always good. Watch out for these situations:
High Leverage
Companies with lots of debt have lower equity, which inflates ROE. This high ROE comes with higher risk. Always check the debt to equity ratio alongside ROE.
Negative Equity
If a company has negative shareholders equity (liabilities exceed assets), ROE becomes meaningless or misleading. Negative equity is usually a red flag.
One-Time Gains
A large one-time gain (like selling a division) can temporarily boost net income and ROE. Look at normalized or operating earnings for a true picture.
Share Buybacks
Stock buybacks reduce equity, which increases ROE even if profits stay flat. This is not necessarily bad, but understand what is driving the ratio.
ROE vs ROA: What is the Difference?
Both measure profitability, but they have different perspectives:
- ROE: Returns from the shareholder's perspective (profit / equity)
- ROA: Returns from total capital perspective (profit / assets)
The gap between ROE and ROA indicates leverage. A company with much higher ROE than ROA is using significant debt.
ROE vs ROA Example
- Net Income: $20 million
- Total Assets: $200 million
- Total Liabilities: $100 million
- Shareholders Equity: $100 million
- ROA: 10% ($20M / $200M)
- ROE: 20% ($20M / $100M)
ROE is double ROA because half of assets are funded by debt.
How to Use ROE in Your Analysis
Step 1: Calculate the Basic ROE
Divide net income by shareholders equity. Use average equity (beginning plus ending divided by 2) for more accuracy.
Step 2: Compare to Peers
How does the company's ROE compare to competitors? Industry leaders often have higher ROE.
Step 3: Analyze the Trend
Is ROE stable, improving, or declining over 5 years? Consistent ROE above 15% is a sign of a quality business.
Step 4: Do the DuPont Breakdown
Understand what drives ROE. Prefer companies where ROE comes from margins and asset efficiency rather than high leverage.
Step 5: Check the Debt Level
Compare ROE to the debt to equity ratio. High ROE with high debt is riskier than high ROE with low debt.
Red Flags to Watch For
- ROE declining over multiple years
- Very high ROE driven primarily by leverage
- ROE much higher than industry average (investigate why)
- Negative or near-zero shareholders equity
- Large gap between ROE and ROA
ROE and Stock Selection
Many successful investors use ROE as a key screening criterion:
- Warren Buffett looks for companies with ROE above 15% consistently
- Peter Lynch favored companies with improving ROE trends
- Quality stock indices often require minimum ROE thresholds
Track ROE Across Your Portfolio
Pro Trader Dashboard helps you monitor Return on Equity and other profitability metrics across your holdings. Identify the highest-quality companies in your portfolio.
Summary
Return on Equity measures how efficiently a company uses shareholder capital to generate profits. An ROE above 15% is generally good, but always compare to industry peers. Use the DuPont analysis to understand what drives ROE, and be cautious of high ROE achieved through excessive leverage. Consistent, high-quality ROE is a hallmark of excellent businesses.
Ready to learn more? Check out our guide on Return on Assets or learn about profit margin analysis.