| Type | Profitability Ratio |
| Formula | Net Income ÷ Shareholders' Equity |
| Target | > 15% |
| High Quality | > 20% |
| Low Quality | < 10% |
| Key component | DuPont Analysis |
formulaROE = Net Income / Shareholders' EquityNet Income is taken from the income statement (trailing 12 months is standard). Shareholders' Equity is taken from the balance sheet (Assets - Liabilities). For more precision, use the average equity over the period.
| Company | Net Income | Avg Equity | ROE | Assessment |
|---|---|---|---|---|
| Company A | $20M | $100M | 20% | Excellent capital efficiency. |
| Company B | $5M | $100M | 5% | Poor return on capital. |
| Company C | $50M | $500M | 10% | Average, possibly utility-like returns. |
Company A is generating $0.20 of profit for every dollar of equity invested. Company B is only generating $0.05. Investors would generally prefer Company A, assuming risk levels are comparable.
| ROE Range | Signal | Interpretation |
|---|---|---|
| > 20% | Exceptional | Strong competitive advantage (moat) or high leverage. Requires DuPont analysis to confirm quality. |
| 15% – 20% | Strong | Healthy business with good capital allocation. Typical of market leaders. |
| 10% – 15% | Average | Matches the long-term market average. Acceptable but not exciting. |
| < 10% | Weak | Inefficient use of capital. Management is destroying value relative to cost of equity. |
| Negative | Loss-making | The company is losing money. ROE is not meaningful in this context. |
ROE is a key input for calculating how fast a company can grow without raising external capital:
formulaSustainable Growth Rate = ROE × (1 - Dividend Payout Ratio)If a company has an ROE of 20% and retains all earnings (0% payout), it can grow equity by 20% annually. If it pays out 50% as dividends, its sustainable growth rate drops to 10%.
A high ROE can be driven by three things: high margins, efficient asset use, or high leverage. The DuPont Identity breaks this down to reveal the quality of the ROE.
formulaROE = Profit Margin × Asset Turnover × Financial Leverage
= (Net Income/Sales) × (Sales/Assets) × (Assets/Equity)When a company buys back its own stock, it reduces Shareholders' Equity (the denominator). This mechanically increases ROE, even if Net Income (the numerator) stays flat. While buybacks can be good capital allocation, an ROE boosted solely by shrinking the denominator is less impressive than one driven by profit growth.
Similar to buybacks, high debt reduces equity relative to assets. A company with 95% debt and 5% equity will have a massive leverage multiplier. This can result in sky-high ROE (e.g., 50%+), but the bankruptcy risk is extreme.
If a company has accumulated losses exceeding its paid-in capital, Shareholders' Equity becomes negative. If Net Income is positive, the ROE calculation results in a negative number, which is confusing. If Net Income is also negative, ROE becomes positive (negative divided by negative), which is nonsensical. Always check the absolute values.
| Sector | Typical ROE | Driver |
|---|---|---|
| Software | 20% – 40% | High Margins, Low Assets |
| Utilities | 8% – 12% | Regulated Returns, High Assets |
| Retail | 15% – 25% | High Turnover, Low Margins |
| Banks | 10% – 15% | High Leverage |
Links price to earnings. High ROE stocks often command higher P/E multiples due to their quality.
Adjusts valuation for growth. High ROE companies often sustain the high growth rates that justify low PEG ratios.
How quality metrics like ROE influence position sizing and risk management in a portfolio.