The Formula
Return on Equity is calculated as:
ROE = Net Income / Shareholders' Equity
If a company earns $10 million in net income and has $50 million in shareholders' equity, its ROE is 20%. That means the company generated 20 cents of profit for every dollar of equity capital.
Why ROE Matters
ROE directly answers the question: how well is management using the capital that shareholders have entrusted to it? High ROE (typically above 15%) suggests the company can reinvest profits at attractive rates, compounding value over time.
Warren Buffett has historically favored companies with consistently high ROE, viewing it as a sign of durable competitive advantage.
The DuPont Decomposition
ROE can be decomposed into three drivers using the DuPont formula:
ROE = Net Margin x Asset Turnover x Equity Multiplier
This reveals whether high ROE comes from strong profitability (high margins), efficient asset use (high turnover), or heavy leverage (high equity multiplier). Two companies with identical ROE may achieve it through very different means, and the distinction matters for risk assessment.
Limitations and Pitfalls
Companies with very low or negative equity (often from aggressive share buybacks or accumulated losses) can show misleadingly high ROE. A company with $1 million in equity and $500,000 in income shows 50% ROE, but the thin equity base may indicate financial fragility.
ROE also ignores debt entirely in its numerator. A company that borrows heavily to boost returns will show higher ROE, but the added leverage increases risk. This is why Apter evaluates ROE alongside Debt-to-Equity and other balance sheet metrics.