What it is
Return on equity (ROE) is the ratio of net income to shareholders' equity:
ROE = Net Income (TTM) ÷ Shareholders' Equity
It answers one question: for every dollar of capital shareholders have left in the business, how much profit did management generate? A 20% ROE means $1 of book equity produced $0.20 of profit over the trailing year.
It's the metric Warren Buffett has cited more than any other when describing what makes a great business. The reason is structural: a business that can compound at 20% ROE for a decade — without diluting its share count or eroding its moat — will produce dramatically more value than one running at 8%, even with identical revenue growth.
What "good" looks like
ROE is highly sector-dependent, but rough anchors:
- Below 10% is a low-quality signal. The business is barely generating returns above its cost of equity.
- 10–15% is acceptable for slow-growth mature businesses (utilities, basic materials).
- 15–25% is the sweet spot. Compounders that durably print this — Microsoft, Visa, Costco — historically reward patient holders.
- Above 30% deserves a hard second look. Either you've found a genuine wide-moat winner, or the denominator has been compressed (see "Common gotchas").
Why it matters
Three reasons ROE is one of our two supplemental grades:
- It catches capital allocation discipline. A CEO who plows retained earnings into below-cost-of-capital projects will see ROE bleed lower year over year. A CEO who returns cash through dividends/buybacks, or finds high-ROIC projects, will hold the line.
- It correlates with moat durability. Sustained high ROE almost requires some structural advantage — switching costs, network effects, brand pricing power, scale economics. Pure commodity businesses (steel, gold mining, refining) cycle their ROE with the price of their product and rarely sustain >20% across a cycle.
- It's the engine of compounding. Per the DuPont identity:
ROE = Net Margin × Asset Turnover × Equity Multiplier. A business that retains earnings and reinvests at high ROE compounds shareholder capital geometrically.
Common gotchas
- Buyback-driven equity depletion. Companies like Boeing, Lowe's, Philip Morris, McDonald's have bought back so much stock that their shareholders' equity is near zero or negative. Mechanical ROE calculations spike to 100%+ or "n/m" (denominator effectively zero). These are real businesses with real moats; the metric just stopped working. We flag this in the model rather than pretend the 300% ROE is meaningful.
- Leverage masquerading as quality. A company that funds itself with debt can show high ROE just because its equity base is small. Banks routinely run 50:1 leverage and 12% ROE — neither number tells you whether the bank is well-run. For financials we look at return on assets (ROA) instead, which strips out the leverage.
- One-time gains. A divestiture or a litigation settlement can spike net income for a quarter. TTM ROE then prints elevated for the next three quarters before normalizing. Always cross-check ROE against ROIC (return on invested capital) — if ROE is high and ROIC is mediocre, something accruals-related is doing the work.
- Sector relativity. A 14% ROE is great for a utility and disappointing for software. Compare ROE within sector, not across.
How we use it
ROE is a supplemental grade — it doesn't sit on the row card alongside the five primary signals (FCF, Rev, D/E, P/E or P/S, PEG), but it feeds the composite score and surfaces in the breakdown tooltip. It also drives the GARP synergy bonus: a name with high ROE, reasonable growth, and a fair multiple gets a small score boost because that combination is statistically rare and historically rewarding.
Bottom line
If you could only check one ratio on a business before you bought it, ROE — properly contextualized for sector and leverage — is the one I'd pick. It's a synthesis of margins, asset efficiency, and capital structure into a single number that tracks moat health over time. Watch it across a full economic cycle; the businesses that hold their ROE through a downturn are the ones worth owning through the next one.