Return on Equity (ROE)

Return on equity, or ROE, is a company's net income divided by its shareholders' equity, measuring how efficiently a business converts the money its owners have invested into it into annual profit.

A company earning $20 million in net income on $100 million of shareholders' equity has an ROE of 20% — for every dollar shareholders have tied up in the business, the company generated 20 cents of profit over the year. A competitor earning the same $20 million on $200 million of equity has an ROE of only 10%, meaning it needed twice as much shareholder capital to produce the identical profit.

What it's used for

ROE is a common way to compare how efficiently different companies use the capital shareholders have entrusted to them, independent of their absolute size. A smaller company can post a higher ROE than a much larger one, since the measure is about efficiency of capital use, not the scale of profit.

The leverage trap

ROE has a well-known flaw: debt can inflate it without any improvement in the underlying business. Because ROE divides by shareholders' equity rather than total capital, a company that borrows heavily and uses the borrowed money to shrink its equity base — through buybacks funded by debt, for instance — can show a rising ROE even while its actual operations haven't gotten any more efficient. A high ROE built substantially on leverage is a different, riskier thing than a high ROE built on genuinely strong operating profitability.

• Compare ROE across companies with similar debt levels, not in isolation.
• A rising ROE paired with rising debt deserves more scrutiny, not less.
• ROE says nothing about whether the company generates actual cash — pair it with free cash flow.