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Return on Equity

A profitability ratio measuring how much net income a company generates per dollar of shareholders' equity.

Financial ReportingInvestment Management

FAQs

What is a good ROE?

ROE above 15% is generally considered good for most industries. Above 20% is excellent. However, the comparison should be to industry peers — a 10% ROE in banking is respectable; in software it's weak. More importantly, ROE should exceed the cost of equity (the return investors require for the risk they're taking). A company with 12% ROE and 15% cost of equity is destroying value despite appearing profitable.

Can ROE be manipulated?

Yes. Stock buybacks reduce shareholders' equity, increasing ROE mechanically. Taking on debt to fund buybacks can push equity near zero, making ROE extremely high or mathematically undefined. Companies can also time large asset disposals or other transactions to favorably affect year-end equity balances. This is why ROIC (Return on Invested Capital = NOPAT ÷ Invested Capital) is often preferred as a manipulation-resistant alternative.

Why does Warren Buffett prefer high-ROE businesses?

Buffett looks for businesses with consistently high ROE (>15% over many years) without excessive leverage, indicating durable competitive advantages that generate strong returns on shareholders' capital. High ROE means retained earnings are being reinvested at attractive rates — compounding within the business. Companies that can reinvest retained earnings at 20%+ ROE are arguably the most powerful compounding machines in equity investing.

Related Terms

Return on Assets

A profitability ratio measuring how efficiently a company generates net income from its total assets.

Return on Investment

A measure of the gain or loss generated on an investment relative to its cost, expressed as a percentage.

Net Margin

The percentage of revenue remaining as net income after all expenses including interest, taxes, and non-operating items.

EBITDA

Earnings Before Interest, Taxes, Depreciation, and Amortization — a proxy for operating cash generation used in valuation and financial analysis.

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Return on Equity (ROE) measures the profitability generated from shareholders' capital, calculated by dividing net income by average shareholders' equity. It is one of the most important metrics for evaluating management effectiveness and the efficiency with which a company uses equity capital to generate profits.

ROE = Net Income ÷ Average Shareholders' Equity × 100

For a company with $5M net income and $25M average equity: ROE = $5M ÷ $25M = 20%.

A sustainable ROE above the company's cost of equity (the return shareholders require for bearing the investment's risk) indicates value creation. The S&P 500 historically averages ROE of approximately 15%. Exceptional businesses — those with strong brands, network effects, or high switching costs — routinely achieve ROE of 25–50%+, while capital-intensive industries may achieve only 5–10%.

The DuPont analysis framework decomposes ROE into three components: Net Margin (profitability of sales) × Asset Turnover (efficiency of asset use) × Financial Leverage / Equity Multiplier (use of debt). This decomposition reveals whether high ROE comes from genuine operational excellence or aggressive debt use.

ROE = Net Margin × Asset Turnover × Equity Multiplier

A company with 30% ROE might achieve this through high margins (premium brand, 15% margin, average turnover, low leverage) or through leverage (thin margins, high asset turnover, high debt). The former is far more durable.

Limitations of ROE: Stock buybacks reduce equity denominator, mechanically inflating ROE without genuine performance improvement. Negative equity (from accumulated losses or buybacks exceeding retained earnings) produces meaningless or misleading ROE. High debt boosts equity multiplier but increases financial risk. For these reasons, ROE should be evaluated alongside return on assets (ROA) and return on invested capital (ROIC).