Definition

ROE (Return on Equity)

The most quoted profitability ratio, and the one most easily manufactured with debt.

Brian Feroldi

By Brian Feroldi, co-founder of Long Term Mindset

Investing since 2004. 3,000+ articles for the Motley Fool. Author of Why Does The Stock Market Go Up?

Last updated

Return on equity measures the profit a company generates for every dollar of shareholder equity. It is net income divided by shareholders' equity. It answers how hard the owners' money is working, and it can be raised substantially without the business improving at all.

FormulaNet Income ÷ Shareholders' Equity

Why it is the most gameable ratio in finance

Equity sits in the denominator, so anything that shrinks equity raises ROE. A company can borrow money and buy back stock, which reduces equity while barely touching net income. The ratio jumps. Nothing about the operations changed, and the business is now riskier than it was.

This is not an abuse so much as the arithmetic working as designed, which is exactly why ROE on its own should never be treated as a measure of quality.

Worked example

A company earns $100M on $1,000M of equity. It then borrows $400M and buys back stock, and interest costs reduce net income to $88M.

Before: $100M ÷ $1,000M = 10.0%
After:  $88M ÷ $600M   = 14.7%

ROE rose almost five points while profit fell. Any investor screening on ROE alone would read this as a substantially better company.

The three components

DuPont analysis splits ROE into net margin, asset turnover and financial leverage, which is the fastest way to see where a number is coming from. Two companies reporting 20% can be completely different: one earning it through margin and efficiency, another through borrowing.

The question to carry into any high ROE is which of the three is doing the work. If it is leverage, you are being paid for risk rather than for quality.

What counts as good

Above 15% sustained is generally strong, and above 20% is excellent if it comes from operations rather than leverage. Below the cost of equity, usually around 8% to 10%, the company is not earning what its owners require.

Negative equity makes the ratio meaningless rather than infinite. Companies that have bought back stock aggressively for years can report negative book equity while remaining highly profitable, at which point ROE stops describing anything and ROIC is the only usable measure.

When to use ROE anyway

For banks and insurers it remains the standard, because leverage is the business rather than a financing choice, and the balance sheet is the product. For almost everything else, ROIC answers the same question without the distortion, since it places debt and equity together in the denominator.

The practical habit: read them side by side. A wide gap between a high ROE and a mediocre ROIC is a leverage story, and it will tell you more than either number alone.

ROE against the three metrics it is confused with

Each formula, when it is the right tool, and what distorts it.

ROE vs ROA vs ROIC vs ROCE infographic by Brian Feroldi, comparing four return metrics across definition, formula, where the inputs are found, when to use each, pros, cons and what to be aware of. Return on equity is net income divided by equity and can be inflated by leverage and buybacks. Return on assets is net income divided by average total assets. Return on invested capital is EBIT after tax divided by long-term debt plus equity less non-operating cash and is best for cross-industry comparison. Return on capital employed is EBIT divided by total assets less current liabilities and can be skewed by high debt levels.
ROE vs ROA vs ROIC vs ROCE. Original graphic by Brian Feroldi.
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Frequently asked questions

Above 15% sustained is strong and above 20% is excellent, provided it comes from margins and efficiency rather than borrowing. Below the cost of equity, roughly 8% to 10%, the company is not earning what its owners require for the risk they carry.
Because equity is the denominator, so anything that shrinks it raises the ratio. Borrowing to buy back stock lifts ROE while making the company riskier and sometimes less profitable. The ratio improves and the business does not.
ROE divides profit by equity alone; ROIC divides after-tax operating profit by debt and equity together. ROIC cannot be flattered by capital structure, which makes it the better measure of the business itself. ROE measures the business plus the financing decisions around it.
Yes, either through a loss or through negative shareholders' equity after years of buybacks. In the second case the ratio stops carrying meaning entirely, and ROIC is the only usable substitute.
A breakdown of ROE into net margin, asset turnover and financial leverage. It shows which of the three is producing the number, which is the fastest way to tell an operationally excellent company from a heavily borrowed one reporting the same figure.

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