Return on Equity (ROE)
Return on equity (ROE) is annual net income divided by shareholders’ equity. It measures how much profit the company generates on the capital its owners actually have invested in the business, making it a core gauge of business quality.
The math
150 million dollars of net income on 1 billion of shareholders’ equity: 15 percent ROE. Now watch leverage distort it.
Take the same business, have it borrow to buy back half its equity: 150 million of profit now sits on 500 million of equity, and ROE doubles to 30 percent. Nothing about the business improved; the balance sheet just got riskier.
| Before buyback | After buyback | |
|---|---|---|
| Net income | $150M | $150M |
| Shareholders’ equity | $1.0B | $500M |
| ROE | 15% | 30% |
Half of a great ROE can be manufactured with debt.
The trap
Treating a high ROE as proof of a great business without checking how it was built. The DuPont decomposition splits ROE into margin, asset turnover, and leverage: two companies at 20 percent ROE can be a high-margin franchise and an ordinary business wearing three turns of leverage.
The second one gives its ROE back, with interest, in the next credit crunch.
The move
Look for ROE that stays above 15 percent across a full cycle, then verify it against debt-to-equity: quality means high returns on conservative leverage. Cross-check with return on invested capital (ROIC), which counts debt in the denominator and cannot be flattered by borrowing.
When ROE is high and ROIC is mediocre, the performance is rented, not owned.