Return on Equity (ROE): Profitability Metric

Return on equity (ROE) measures how much profit a company generates for each dollar of shareholder capital. Warren Buffett reportedly considers sustained high ROE a hallmark of great companies. For traders, ROE separates businesses that compound capital efficiently from those that don't.

The formula

ROE = Net income ÷ Average shareholders' equity × 100

A company earning $10 million on $50 million of equity has a 20% ROE. Each dollar of capital generated 20 cents of profit.

How to interpret ROE

The S&P 500 long-term average is roughly 15%. Companies that consistently exceed 20% with low leverage are rare and valuable. ROE tells you whether the business compounds capital — a 25% ROE company can reinvest profits and double its equity base every three years, while a 5% ROE company takes 14 years.

The DuPont decomposition

ROE alone doesn't tell you why it's high. DuPont breaks it into three drivers:

ROE = Net profit margin × Asset turnover × Equity multiplier

A high ROE driven by margin and turnover is high quality. A high ROE driven by the equity multiplier is leverage — and leverage cuts both ways. ROIC (NOPAT ÷ invested capital) is often the cleanest measure because it strips out financing choices. ROE can be inflated by debt; ROIC cannot.

Reading in practice

1. Compare to industry peers — relative matters more than absolute
2. Check 5-year trend — consistency reveals quality
3. Run DuPont — understand why ROE is high or low
4. Pair with debt levels — high ROE + high debt is fragile
5. Compare to cost of equity — ROE above ~8–10% creates value

Common mistakes

• Comparing ROE across sectors — banks and software aren't comparable
• Ignoring leverage — high ROE from debt isn't quality
• Treating buyback-boosted ROE as growth — fewer shares, not more profit
• Forgetting one-time items — a tax benefit inflates ROE for one year
• Using ending equity instead of average — average smooths mid-year changes

ROE is the headline quality metric. Pair it with DuPont, leverage, and the long-term trend to separate genuinely great businesses from those just looking the part.