Is a 40% ROE better than 20%?
Return on equity (ROE) shows how much a company earns on the money shareholders have put in, and higher looks better. But the same ROE can mean very different things depending on how it was produced. An ROE built on heavy borrowing can collapse quickly when conditions turn.
Below, we look at how to read ROE alongside return on assets (ROA), how debt affects ROE, and how DuPont analysis breaks ROE into profit margin, asset turnover, and leverage, using a hypothetical comparison. It also covers matching denominators and periods and what to check in the filings.
Calculating ROE and ROA
ROE is net income divided by shareholders' equity; ROA is net income divided by total assets. As the SEC's Beginners' Guide to Financial Statements explains, total assets equal liabilities plus equity, so ROA shows what the company earns on all its resources, while ROE shows what it earns on the shareholders' portion.
The difference between the two comes from debt. A company with no debt has equal assets and equity, and therefore equal ROE and ROA. The more debt it carries, the smaller equity is relative to assets, and the further ROE rises above ROA for the same profit.
A hypothetical comparison with DuPont analysis
DuPont analysis splits ROE into net profit margin × asset turnover × financial leverage (total assets ÷ equity). The table applies it to two hypothetical companies with the same net income.
| Item | Company A | Company B |
|---|---|---|
| Net income | 100 | 100 |
| Revenue | 800 | 2,000 |
| Total assets | 1,000 | 2,500 |
| Shareholders' equity | 500 | 250 |
| Net profit margin | 12.5% | 5.0% |
| Asset turnover | 0.8× | 0.8× |
| Financial leverage | 2× | 10× |
| ROA | 10.0% | 4.0% |
| ROE | 20.0% | 40.0% |
Company B's ROE is twice A's, but most of it comes from tenfold leverage. On earning power from its assets (ROA), A is two and a half times stronger.
The leverage effect
Borrowing to expand assets raises ROE when those assets earn more than the interest cost. When returns on assets fall, interest still has to be paid, so ROE drops quickly, and losses eat into equity.
As a hypothetical example, if Company B's net income halves from $100 million to $50 million, its ROE falls from 40% to 20%. A $50 million loss would wipe out 20% of its $250 million equity in a single year; the same loss would cost Company A only 10% of its $500 million. Leverage magnifies outcomes in both directions.
Industry differences
Banks and insurers carry large liabilities by the nature of their business, deposits and policy reserves, so leverage of ten times or more is common. ROA around 1% can still produce ROE above 10%, which makes direct comparison with manufacturers misleading.
Software and platform companies, by contrast, often have few assets and high turnover, producing high ROA and ROE together. Comparing ROE works best within an industry, and by looking at each of the three DuPont components.
Matching denominators and periods
Use the average of opening and closing equity or assets rather than the year-end figure. Large share issues, buybacks, or acquisitions during the year distort year-end-only calculations. When using quarterly profit, annualize it or use the trailing four quarters.
Very small or negative equity makes ROE abnormally high or meaningless. Companies that have bought back large amounts of stock can also show inflated ROE because their equity has shrunk, so check the reason behind a high figure.
FINRA's guide to evaluating stocks presents ROE alongside other measures for good reason: no single ratio tells the whole story, and the comparison is only as good as the consistency of the inputs.
A checklist
Using the 10-K on EDGAR, calculate and check ROE and ROA yourself.
- Find net income attributable to the company on the income statement, and equity attributable to the company and total assets on the balance sheet.
- Calculate ROE and ROA for three to five years using average equity and average assets.
- Add revenue to split ROE into profit margin, asset turnover, and leverage.
- Check total debt and interest coverage to judge how risky the leverage is.
- If net income includes one-off items, or equity has shrunk through buybacks, calculate an adjusted ROE as well.
Limits of ROE and ROA
Both ratios rest on accounting equity and assets, so for companies whose value lies in brands or technology that never appear on the balance sheet, they may not reflect real efficiency.
The companies in the table are hypothetical. For real analysis, use the latest filings, checking how recent each one is, and before judging a high ROE, find out whether it comes from margin, turnover, or leverage.