Return on Equity (ROE) Explained

Return on Equity measures how efficiently a company generates profits from shareholders' investment. It's one of Warren Buffett's favorite metrics. [DEFINITION] Return on Equity (ROE): A measure of financial performance calculated by dividing net income by shareholders' equity, showing how effectively a company uses shareholder capital to generate profits. [FORMULA] ROE = Net Income ÷ Shareholders' Equity × 100 ### Understanding ROE ROE answers: "For every dollar shareholders have invested, how much profit does the company generate?" [EXAMPLE] Apple: - Net Income: $97 billion - Shareholders' Equity: $62 billion - ROE = $97B ÷ $62B = 156% Apple generates $1.56 in profit for every $1 of shareholder capital—extraordinarily high. ### What's a Good ROE? | ROE Level | Interpretation | |-----------|----------------| | Under 10% | Below average, may struggle | | 10-15% | Average for most industries | | 15-20% | Good, above average | | 20-30% | Excellent, strong business | | Over 30% | Exceptional (verify sustainability) | [TIP] Compare ROE to industry peers. Banks typically have 10-15% ROE (capital-intensive), while software companies may have 30%+ (capital-light). ### The DuPont Analysis ROE can be decomposed to understand its drivers: [FORMULA] ROE = Profit Margin × Asset Turnover × Financial Leverage Or more specifically: ROE = (Net Income/Sales) × (Sales/Assets) × (Assets/Equity) This shows three ways to achieve high ROE: **1. High Profit Margins** Companies like Apple charge premium prices, generating more profit per sale. **2. High Asset Turnover** Companies like Walmart turn over inventory quickly, generating more sales per dollar of assets. **3. Financial Leverage** Using debt increases equity returns (but also risk). [EXAMPLE] Two companies with 20% ROE: | Company | Margin | Turnover | Leverage | Risk | |---------|--------|----------|----------|------| | Software Co. | 25% | 0.8x | 1.0x | Low | | Retailer | 4% | 2.5x | 2.0x | Higher | Same ROE, very different businesses. The software company's ROE comes from high margins; the retailer's from high turnover and leverage. ### The Leverage Warning [WARNING] High ROE from excessive leverage is risky: - Works great in good times - Can destroy a company in downturns - Check debt-to-equity alongside ROE [EXAMPLE] During 2008: - Companies with low leverage survived - Highly leveraged companies went bankrupt despite previously high ROE - Lehman Brothers had ~30% ROE before collapse ### ROE Trends Matter Look at ROE over time: **Improving ROE:** Business getting more efficient **Stable high ROE:** Sustainable competitive advantage **Declining ROE:** Competition eroding advantages **Volatile ROE:** Cyclical business or inconsistent execution [KEY] Warren Buffett looks for companies with consistently high ROE (15%+) over many years. This indicates a durable competitive advantage—a "moat" around the business. ### ROE vs. ROIC [DEFINITION] Return on Invested Capital (ROIC): Measures return on all capital (equity + debt), not just equity. [FORMULA] ROIC = Net Operating Profit After Tax ÷ (Equity + Debt) ROIC is often preferred because: - Accounts for debt levels - Not inflated by high leverage - Better comparison across capital structures [EXAMPLE] Two companies: | Company | ROE | Debt | ROIC | |---------|-----|------|------| | A | 25% | Low | 20% | | B | 25% | High | 12% | Same ROE, but Company A generates better returns on total capital. Company B's ROE is artificially boosted by leverage. [EXERCISE] A company has Net Income of $20 million, Total Assets of $200 million, and Total Liabilities of $120 million. Calculate Shareholders' Equity and ROE. |ANSWER| Shareholders' Equity = Assets - Liabilities = $200M - $120M = $80M. ROE = $20M ÷ $80M = 25%. This is excellent if sustainable and not purely from leverage. [SCENARIO] You find a company with 35% ROE—exceptional! But investigation reveals: - Debt-to-Equity ratio is 3.0x (very high) - Profit margin is only 5% (thin) - Most competitors have 15% ROE with 0.5x leverage The high ROE is an illusion created by leverage. In a downturn, this company could struggle while lower-ROE but conservatively financed competitors survive. Always understand the SOURCE of high ROE before investing.