A company reports a return on equity of 28%. Another reports 11%. If you are choosing an investment, the first number is hard to ignore. It seems to say that one business is much better at turning its owners’ money into profit.
Sometimes that is true. But a high return on equity can also come from heavy borrowing or a very small amount of equity. Before treating it as a sign of quality, it helps to understand what went into the calculation. The number is useful only when you can explain why it looks the way it does.
What return on equity actually measures
Return on equity, usually called ROE, compares a company’s net profit with its average shareholders’ equity. It asks how much profit the business made relative to the equity recorded in its accounts. I will use full financial years throughout this article.
Shareholders’ equity is what remains on the balance sheet after subtracting liabilities from assets. It can include money investors put into the company and profits the company kept rather than paid out. It is an accounting figure, not a separate pile of cash.
The money may be tied up in equipment, stock or other assets. Nor is equity the same as the company’s value on the stock market. If those terms feel unfamiliar, my guide to reading a balance sheet explains how assets, liabilities and equity fit together.
The basic calculation is net profit divided by average shareholders’ equity, multiplied by 100. Net profit here means profit after expenses, including interest and tax. Using sales or operating profit instead would answer a different question.
A simple example
Imagine a small listed company starts its financial year with $2 million in equity and ends with $3 million. The average of those two figures is $2.5 million. It reports net profit of $300,000 for the year.
Divide $300,000 by $2.5 million and you get 0.12, or 12%. That is its ROE under this calculation. For every dollar of average equity recorded in the accounts, the company made twelve cents of annual profit.
| Item | Amount |
|---|---|
| Equity at the start of the year | $2 million |
| Equity at the end of the year | $3 million |
| Average equity | $2.5 million |
| Net profit for the year | $300,000 |
| Return on equity | 12% |
Why use an average? Profit covers a period of time, while a balance sheet captures a single date. Averaging the opening and closing figures is a simple way to bring the two closer together. If the company raised a large amount of money during the year, a more detailed average may be more useful.
Check the method when comparing figures from different websites or annual reports. Some use closing equity rather than an average. Others focus on ordinary shareholders and adjust the profit figure to match. A fair comparison needs figures calculated on the same basis.
A high number can reflect a good business
Some companies earn strong profits without needing much capital. A business may have loyal customers, a product people will pay more for or an efficient way of delivering its service. Those strengths can support a high ROE.
Consistency matters. A company that earns a healthy return over several years, with manageable debt and no reliance on unusual gains, gives you more to work with than one exceptional result.
There is no single percentage that makes every company attractive. A supermarket, a software company and a bank use money in very different ways. Their accounting figures can also reflect different histories. Compare similar businesses and look at how each one has changed over time.
Even then, a strong past does not guarantee a strong future. Competition can grow, customers can leave and a once successful product can lose its appeal. ROE describes what happened in the period being measured.
Borrowing can make ROE look better
Consider two imaginary businesses, each with $1 million in assets throughout the year. One is funded with $800,000 of equity and $200,000 of debt. The other uses $250,000 of equity and $750,000 of debt.
The first company earns $80,000 after interest and tax. Its ROE is 10%. The second earns only $50,000 after those costs. Yet its ROE is 20%, because its profit is divided by a much smaller equity figure.
The higher percentage does not mean the second company earned more money. It means that less equity sits underneath the business. More of its funding comes from lenders, who still expect payment when trading becomes difficult.
Borrowing is not automatically a mistake. It can help finance useful investments. But it changes the risk shareholders face. A fall in profit or an increase in borrowing costs can put greater pressure on a heavily indebted company.
This is why ROE is more useful alongside a company’s solvency ratio. Solvency helps you see how much of the business is funded by equity. Profitability and financial strength belong in the same conversation.
Share buybacks can change the denominator
A company can use cash to buy back its own shares. This usually reduces the equity recorded in its accounts. If profit stays similar while average equity falls, ROE can rise even though the underlying business has not become more profitable.
The same broad issue can arise after large dividends. Money has left the company and the equity figure is smaller. Returning spare cash can make sense, but the resulting rise in ROE is not proof that the company has become better at selling its products.
Ask what caused the change. Did profit grow? Did equity shrink? Did the company borrow to fund a payout? Those are different stories, even if the final percentage looks equally impressive.
When equity is close to zero, ROE can become extreme and difficult to interpret. Negative equity creates an even bigger problem. A loss divided by negative equity can produce a positive percentage. That does not turn the loss into good news. In such cases, step back from the ratio and read the accounts.
Check the profit as well as the equity
A business might sell a building and report a large gain. That gain can boost net profit and ROE for the year. It does not mean the normal business will produce the same result next year.
A weak year also needs context. A large write-down can reduce reported profit, but you should not simply ignore it because management calls it unusual. It may show that an earlier investment has gone wrong.
Start with the reported result and understand the major adjustments. My guide to reading a profit and loss statement explains where those results come from. Compare them with earlier years and check whether the business is generating cash from its normal activities.
Profit and cash are not interchangeable. A company may record sales before customers pay their bills. It may also need to spend heavily replacing worn-out equipment. A strong ROE alone cannot tell you whether the business has enough cash to meet its commitments.
Your investment return is a different number
If a company has an ROE of 20%, buying its shares does not entitle you to a 20% annual return. You pay the market price for those shares, which may be far above the equity recorded in the accounts.
A widely admired business can still be a disappointing investment if the purchase price assumes years of near-perfect results. Even decent profits may not meet those expectations. The share price can fall while the company remains profitable.
Your own return depends on the price you pay, any distributions you receive and the price at which you eventually sell. Fees and taxes can affect what you keep. Company performance matters, but so does the amount you pay for it.
Use ROE to ask a better question
When a high ROE catches your eye, ask what supports it. Look for repeatable profits, a clear explanation of changes in equity and a level of debt you understand. Compare several years and businesses with similar activities.
You do not need to calculate every ratio in an annual report. But you should be able to describe the main reason a company looks attractive. If the explanation stops at a large percentage, the research is unfinished. ROE can point you towards a worthwhile question. It cannot make the investment decision for you.