Return on Equity (ROE) Explained: Formula, Examples and the Traps

What ROE measures

Return on equity answers a simple question: for every euro shareholders have invested in a company, how much profit does it earn in a year? The formula is net profit divided by shareholders’ equity, the value of the company’s assets minus its debts as shown on the balance sheet. If a company earns €15 million in a year and its shareholders’ equity is €100 million, its ROE is 15%.

Investors such as Warren Buffett and Terry Smith pay close attention to how much profit a business earns on the capital it uses. A company that can keep reinvesting its profits at a high rate of return can grow its value year after year without needing much new money, which is one of the most powerful forces in long-term investing.

A worked example

Take two hypothetical companies, each with €100 million of shareholders’ equity. Company A earns €8 million: an ROE of 8%. Company B earns €20 million: an ROE of 20%. If both reinvest all their profits at the same rates, after ten years Company A’s equity would have grown to about €216 million and Company B’s to about €619 million. The difference comes entirely from the rate at which each turns its capital into profit.

What counts as a good ROE?

There is no single right number. Banks, utilities, software companies and supermarkets have very different business models, so ROE is most useful when you compare a company with others in the same industry, and with its own history over five or ten years. Many investors look for companies that have kept ROE above about 15% through good and bad years, but a steady 12% can be more impressive than a 30% that appears once and disappears.

Breaking ROE into its parts

A useful way to understand where ROE comes from is to split it into three parts, often called the DuPont analysis:

• Profit margin: how much of each euro of sales becomes profit.
• Asset turnover: how many euros of sales the company generates from each euro of assets.
• Financial leverage: how much the company’s assets are funded by debt rather than by shareholders.

Two companies with the same ROE can be very different underneath. One may earn high margins with little debt; the other may earn thin margins and borrow heavily. The first is usually the safer business.

A high ROE is only impressive if it does not come from borrowed money.

The traps

• Debt: borrowing reduces shareholders’ equity relative to assets, which pushes ROE up even if the business itself has not improved — and adds risk.
• Share buybacks: when a company buys back its own shares, equity falls, which can lift ROE without any change in profits.
• Negative or tiny equity: companies with very low or negative equity after years of buybacks or losses can show huge or meaningless ROE figures.
• One-off gains: selling a division or revaluing assets can inflate profit, and ROE, for a single year.

That is why many analysts also look at return on capital employed (ROCE) or return on invested capital (ROIC), which include debt in the capital base and are harder to flatter with borrowing.

How to use ROE as an investor

ROE is a useful first filter, not a buying signal. A company with a high, stable ROE, modest debt and a good reason why competitors cannot easily copy it is worth a closer look; a company with a sudden jump in ROE deserves questions. And remember that the share price matters: a great business bought at too high a price can still be a poor investment. If you invest through a broad index fund, you already own the high-ROE companies in the market, without having to pick them. This guide is general education, not personal financial advice.

This article is educational and general in nature. It isn’t personalized investment, tax, or legal advice — always weigh your own circumstances, or talk to a licensed professional, before making financial decisions.

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