ROE

Shareholders' equity, or net worth, is share capital plus reserves. When equity changes a lot during the year, use the average of the opening and closing figures.

What counts as good

It depends on the industry, so compare within a sector and over several years. As a general guide used on this site, above 20% is good in most industries and harder to reach in banks and heavy industries. About 15% is a sensible floor for an individual stock, because a diversified equity fund or a fixed deposit offers a return with less company-specific risk.

Breaking it down: DuPont analysis

ROE = net profit margin x asset turnover x financial leverage (assets divided by equity). The first two show how well the business runs; the third shows how much of it is funded with debt. Two companies with the same ROE can get there in very different ways, and an ROE built on leverage is more fragile than one built on margins and turnover.

What inflates ROE

• Debt. Borrowing keeps equity small relative to assets, which lifts ROE even if the business is no better. Check ROCE, which counts debt in the capital base, alongside it.
• Buybacks and large dividends. Returning cash reduces equity and raises ROE.
• Past losses. A company whose losses have eaten into its equity can show a very high ROE on a tiny equity base once it turns profitable.

Where to find it

Net profit is in the statement of profit and loss. Share capital and reserves (other equity) are in the balance sheet. Where there are minority shareholders, use the profit attributable to the owners of the company.

Common mistakes

• Comparing ROE across industries, for example a software company with a steel maker.
• Reading one year in isolation. Look for consistency over five to ten years.
• Ignoring negative equity, where ROE stops meaning anything.

Questions investors ask

Is a higher ROE always better? No. Look at ROE together with debt. A slightly lower ROE with no debt can be the stronger business.

What is the difference between ROE and ROCE? ROE divides net profit by equity. ROCE divides operating profit by equity plus debt, so it shows how the whole business performs before financing choices.

Why do banks usually show a lower ROE than software companies? A bank must hold a large amount of regulatory capital against its loans, which keeps equity high relative to profit. A software company needs little capital to grow, so the same profit sits on a much smaller equity base.