Return on equity (ROE)

In simple terms

Shareholders' money in a company is its equity: the capital they put in plus the profits the company has kept over the years. Return on equity (ROE) asks how much profit the company earns on that money each year.

An ROE of 18% means the company earned ₹18 of profit for every ₹100 of shareholders' equity. If it can keep reinvesting profits at that rate, shareholders' equity, and in time the value of the business, compounds quickly.

Calculating ROE

Use average equity: the equity at the start of the year plus the equity at the end, divided by two. Profit is earned through the year, so comparing it with the year-end figure alone can distort the result, especially for a fast-growing company or one that raised capital during the year.

Look at ROE over five or ten years. A single year can be flattered by a one-off gain or depressed by a one-off charge, as the quality of earnings lesson explains.

The DuPont breakdown

ROE can be split into three parts, a method known as DuPont analysis:

Multiplying the three gives net profit ÷ equity, which is ROE. The breakdown shows how a company earns its return:

• Net margin: how much profit each rupee of sales brings. High for businesses with pricing power.
• Asset turnover: how much revenue each rupee of assets produces. High for retailers and distributors, low for utilities and heavy industry.
• Financial leverage: how much of the assets is funded by borrowing rather than equity. High for banks and heavily indebted companies.

How debt and buybacks flatter ROE

Because ROE divides by equity, anything that shrinks equity raises ROE, even if the business is unchanged.

• Borrowing to fund the business instead of using equity means less equity for the same profit, as long as the interest cost is lower than the return on the assets.
• Buybacks and large dividends return equity to shareholders. Profit stays the same, equity falls, and ROE rises.
• Accumulated losses or write-downs shrink equity. A company that has written off large amounts can show a high ROE on what is left.

None of these is necessarily bad. Returning surplus cash that the business does not need can be sensible. But they mean ROE alone cannot tell you whether the business itself has improved. Compare ROE with return on capital employed, which includes debt and is less affected by how the business is financed.

When ROE is meaningless

If equity is very small, ROE can be enormous; if equity is negative, because past losses exceed all the capital put in, ROE is meaningless. In such cases, look at profit relative to total capital or assets instead.

Why it matters

ROE is one of the most widely quoted measures of business quality, and consistently high ROE from margins and turnover often signals a competitive advantage. It is also closely linked to valuation: companies that earn high returns on equity and can reinvest at those returns tend to be worth more per rupee of book value, as the P/B ratio lesson explains. Understanding where ROE comes from stops you paying a premium for returns that are really borrowed.

Limitations

ROE depends on accounting: book equity reflects historical costs and past write-offs, not what the assets are worth today. It ignores risk, so a high ROE with heavy debt looks as good as a high ROE with none. It also says nothing about growth. Use it together with debt measures, cash flow and other return ratios.

Common mistakes

• Treating a high ROE as proof of quality without checking leverage.
• Using year-end equity for a company whose equity changed a lot during the year.
• Ignoring the effect of buybacks on equity.
• Comparing ROE across very different industries, where normal leverage and turnover differ.

Try it yourself

Choose two listed companies in different industries.

1. From their latest annual reports, calculate ROE using average equity.
2. Calculate net margin, asset turnover and financial leverage, and check that they multiply to ROE.
3. Note which part contributes most to each company's ROE.
4. Repeat for five years and see whether the source of ROE has changed.