Net income divided by shareholders' equity - measures how efficiently a company generates profit from the money shareholders have invested.
ROE = Net Income ÷ Shareholders' Equity (× 100 to express as a percentage). A ROE of 20% means the company generates USD 20 of profit for every USD 100 of equity. It is one of Warren Buffett's preferred metrics for identifying durable competitive advantages: companies sustaining high ROEs (15%+) over multiple years typically have pricing power, brand strength, or network effects that prevent competition from eroding returns.
ROE can be decomposed using the DuPont formula: ROE = Net Profit Margin × Asset Turnover × Financial Leverage. This decomposition reveals what is driving a high ROE - is it genuine operating efficiency (high margins, high asset utilisation) or simply high debt leverage? A company boosting ROE by taking on debt rather than improving operations faces risks if earnings fall and debt cannot be serviced.
High ROE alone is not sufficient - the quality of earnings matters. Aggressive accounting (accelerated revenue recognition, capitalised expenses) can inflate earnings and therefore ROE without generating actual cash. Comparing ROE with return on invested capital (ROIC) and cash return on equity helps identify whether high accounting returns translate into real cash generation.
For stock traders, sustained high-ROE companies tend to compound in value over time and are frequently identified in quality-factor investment strategies. They often trade at P/B multiples well above 1.0 - the premium reflecting the market's willingness to pay for the superior earning power of the equity base.
Worked Example
Company A: Net income USD 500M, Shareholders' equity USD 2,500M. ROE = 500 ÷ 2,500 = 20%. DuPont breakdown: Net margin 15% × Asset turnover 0.8 × Leverage 1.67 = 20%. The high ROE is driven by strong margins and moderate leverage - a quality signal compared to a competitor achieving similar ROE primarily through high debt.