In-Depth Analysis of Return on Equity (ROE): The Investment Logic Behind the ROE Formula and Stock Selection Pitfalls

When it comes to financial indicators, many investors’ first reaction is ROE (Return on Equity), but few truly understand this metric. This article will analyze from the core concept, derivation of the ROE formula, its relationship with other indicators, and practical stock selection strategies, helping you avoid the high ROE trap.

The Essence of Return on Equity: Measuring the Profitability of Own Capital

ROE, or Return on Equity, reflects the ratio of a company’s after-tax profit to its net assets. Simply put, it shows how much money can be earned with 100 units of equity. The higher the indicator, the more efficient the company is at utilizing its capital.

It is important to note that asset composition includes two main sources: direct investments from shareholders (share capital, capital reserves, retained earnings), and funds borrowed or temporarily occupied by the company. Reasonable use of financial leverage can improve capital efficiency, but excessive borrowing amplifies risk, and insufficient capital can waste potential. ROE is a key indicator to measure this balance.

Complete Derivation and Practical Calculation of the ROE Formula

Basic ROE formula: Return on Equity = Net Profit ÷ Net Assets

Where net profit = after-tax profit + profit distribution; net assets = owner’s equity + minority interests.

In practical application, if there are no profit distributions or mergers, the calculation simplifies to: ROE = After-tax profit ÷ Owner’s equity.

For example, Company A has net assets of 1,000 units and an after-tax profit of 200 units, so its ROE is 20%; Company B has net assets of 10,000 units and an after-tax profit of 500 units, so its ROE is only 5%. Clearly, Company A’s capital efficiency is much higher than Company B’s.

In stock market calculations, a weighted average method is used:

ROE = P ÷ [E0 + NP ÷ 2 + Ei × Mi ÷ M0 - Ej × Mj ÷ M0]

Where P is the profit for the reporting period, NP is net profit, E0 is net assets at the beginning of the period, Ei is new assets added, Ej is assets decreased, M0 is the number of months in the reporting period. This weighted approach more accurately reflects the annual change in capital efficiency.

The Fundamental Differences Between ROE, ROA, and ROI: The Three Major Return Rates

ROA (Return on Total Assets) focuses on how much profit is generated per unit of assets, calculated as: ROA = Net Income ÷ Total Assets. This indicator assesses whether management effectively utilizes all company assets. ROA emphasizes asset efficiency, while ROE focuses on shareholder returns.

ROI (Return on Investment) refers to the economic return of a specific investment activity, calculated as: ROI = Annual Profit ÷ Total Investment × 100%. Compared to the previous two, ROI is simpler but ignores the time value of money and is often time-specific, based on data from a particular year.

All three indicators reflect profitability, but differ in dimension: ROE emphasizes shareholder equity efficiency, ROA measures total asset efficiency, and ROI focuses on individual investment returns. Investors should choose the appropriate indicator based on their analysis purpose.

The Truth About High ROE: Why ROE Over 25% Is Often Unsustainable

Warren Buffett has explicitly stated that if he had to choose one indicator for stock selection, he would choose ROE, believing that companies maintaining over 20% ROE for many years are worth attention. However, this statement can be misunderstood.

In reality, ROE can be expressed as: ROE = ( Market Value ÷ Net Assets ) ÷ ( Market Value ÷ Net Profit ) = PB ÷ PE. For investors, lower PE and PB ratios are safer, so a high ROE might seem attractive but actually hides risks.

For example, a stock with PE of 10 and PB of 2 has an ROE of 20%; if PE remains 10 but PB rises to 5, ROE jumps to 50%. However, such extreme ROE levels are often unsustainable because:

1. Capital Inflows: Extremely high ROE attracts competition, and companies lacking core competitiveness are easily replaced by new entrants.
2. Limited Growth Space: Increasing ROE from 2% to 4% is relatively easy, but from 20% to 40% is much harder due to different industry environments.
3. Valuation Bubbles: Extremely high PB ratios often imply unsustainable expectations; when bubbles burst, prices can fall sharply.

Therefore, ROE is not simply “the higher the better,” but should be evaluated based on a stable, continuous growth trend.

Practical Stock Selection Strategy: How to Use ROE to Find Quality Companies

According to historical statistics, stocks maintaining an ROE above 15% over the long term are few, and companies that can achieve this under reasonable valuation (PE 10-15 times, PB 2-3 times) are even rarer.

Effective ROE-based stock selection criteria include:

• ROE set between 15%-25%: Too low indicates insufficient capital efficiency; too high may imply hidden risks.
• Focus on long-term ROE data over 5+ years: While past data cannot predict the future, it reflects whether the company’s profitability has been consistently improving.
• Prioritize companies with a continuous upward trend in ROE: Stable growth is far better than volatility.
• Combine with valuation metrics like PE and PB: To avoid pitfalls of single-indicator selection.

ROE Rankings in Major Markets in 2023 (Reference)

Taiwan Stock Market Top 20 ROE

Data as of August 2023

US Stock Market Top 20 ROE

Data as of August 2023

Hong Kong Stock Top 20 ROE

Data as of August 2023

Quick Tools to Check ROE

To find the ROE of a specific stock, you can use free platforms like Google Finance or Yahoo Finance. To screen for stocks with top ROE rankings, visit professional stock screening websites and customize filters based on market, ROE value, market cap, and other parameters.

Conclusion: Investment Philosophy for ROE-Based Stock Selection

ROE is indeed one of the core indicators in investment analysis, but the key lies in understanding its underlying logic rather than blindly chasing high numbers. High or low ROE is not an absolute standard; focus should be on a stable, long-term growth trend and reasonable valuation ranges. Cross-verifying ROE with PE, PB, and other indicators, combined with independent thinking and risk awareness, will help you find truly quality investment targets in the stock market.