Essential Financial Metrics Investors Must Know: Understanding a Company's Profitability Through ROE

Why Focus on ROE? Warren Buffett’s Stock Selection Secret

The investing legend Warren Buffett has publicly stated that if he could only use one indicator to evaluate a company, he would choose ROE. This simple yet powerful financial metric directly reflects how efficiently a company uses shareholders’ funds. So, what exactly is ROE? Why is it so important? This article will guide you to a deep understanding of this indispensable tool in investment decision-making.

Core Definition and Practical Significance of ROE

ROE stands for Return on Equity, also known as shareholders’ equity return, net asset return, or equity profit margin. Simply put, it measures how much net profit a company generates for each dollar of shareholders’ equity invested.

Calculation is straightforward: ROE = Net Profit ÷ Net Assets

Net assets include shareholders’ invested capital, corporate reserves, and retained earnings. The higher the ratio, the more profit the company makes with shareholders’ money, indicating better management efficiency.

Company funding sources consist of two parts: one is the shareholders’ direct invested capital, and the other is external funds obtained through debt financing. Moderate use of financial leverage can improve capital efficiency, but excessive borrowing increases financial risk. ROE is a key indicator to measure the efficiency of using this equity capital.

Understanding ROE Calculation Methods in Depth

In simple cases, the formula is: ROE = After-tax Profit ÷ Shareholders’ Equity

For example: Company A has net assets of 1,000 yuan and an annual after-tax profit of 200 yuan, resulting in an ROE of 20%; Company B has net assets of 10,000 yuan and an after-tax profit of 500 yuan, ROE is 5%. Although B’s total profit is higher, Company A generates more profit per unit of capital.

In actual stock markets, calculations are more complex, requiring the use of weighted average return on net assets, considering effects of issuing new shares, debt-to-equity swaps, share buybacks, etc., on net assets. This design of ROE compensates for the shortcomings of earnings per share—even if a company issues bonus shares causing EPS to decline, ROE can accurately reflect the company’s true profitability without change.

ROE vs ROA vs ROI: How to Distinguish the Three Major Indicators

Investors often confuse these three important metrics; understanding their differences is crucial.

ROA (Return on Assets) measures how much net profit a company creates using all assets (including shareholders’ invested capital and borrowed funds). The formula is: ROA = Net Income ÷ Total Assets. It reflects management’s efficiency in utilizing all assets, not just shareholders’ capital.

ROI (Return on Investment) focuses on specific investment projects, calculated as: ROI = Average Annual Profit ÷ Total Investment × 100%. Its advantage is simplicity, but it doesn’t consider the time value of money and is usually time-sensitive.

ROE (Return on Equity) concentrates on the return generated on shareholders’ invested capital, serving as the most direct indicator of shareholders’ investment returns. Each has its focus; investors should use them flexibly based on analysis purposes.

The Real Trap of ROE Stock Selection: Higher Is Not Always Better

Many investors’ first reaction is “the higher the ROE, the better,” but in practice, this perception can lead to serious losses.

Mathematically, an important relationship is: ROE = PB ÷ PE. PB is the Price-to-Book ratio, PE is the Price-to-Earnings ratio. This means that to make ROE very high, one must either lower PE (stock undervaluation) or raise PB (net assets overestimation).

The Trap of Low PE with High ROE: Suppose a stock has a PE of 10x and a PB of 2x, resulting in an ROE of 20%. But if PE is 10x and PB is 5x, ROE jumps to 50%. Such abnormally high ROE is often unsustainable because the market will eventually realize the overestimated net asset value, leading to a stock price correction.

Risks of Increasing Competition: Very high ROE can attract new entrants, intensifying competition. If the company’s core competitiveness is weak, it can be easily replaced by emerging firms. Also, companies with already high ROE have limited room for future growth. Doubling ROE from 2% to 4% is relatively easy, but from 20% to 40% is extremely difficult.

Scientific Standards for ROE Stock Selection

Based on the above analysis, investors should adopt the following stock selection criteria:

ROE should ideally be between 15%-25%. This range avoids the problems of too low profitability and the risks associated with excessively high ROE.

Observe at least a 5-year ROE trend. Historical data can truly reflect whether a company’s profitability is steadily improving. The ideal scenario is a continuous upward trend, indicating increasing competitiveness.

Avoid being fooled by a single year’s high ROE, which may be due to special factors (such as asset impairment, share repurchases, etc.). Consistently stable moderate ROE levels are often more valuable than volatile high ROE.

2023 Market ROE Rankings Overview

Below are the top companies by ROE in Taiwan stocks, US stocks, and Hong Kong stocks in 2023. Note that extremely high ROE (e.g., over 100%) often result from small net assets or accounting adjustments; investors should exercise caution when selecting stocks.

Top 10 Taiwan Stocks by ROE

Data as of August 2023

Top 10 US Stocks by ROE

Data as of August 2023

Top 10 Hong Kong Stocks by ROE

Data as of August 2023

How to Check Individual Stock ROE Data

If you want to learn about a stock’s ROE performance, you can obtain data through:

International Markets: Google Finance and Yahoo Finance provide detailed ROE data and ranking filters for US and Hong Kong stocks. Investors can customize markets and parameters to quickly find suitable targets.

Taiwan Market: Major Taiwanese brokerage websites and professional stock screening platforms offer ROE ranking services, supporting sorting from high to low.

Practical Investment Tips for ROE

ROE is indeed a golden indicator for evaluating a company’s profitability, but it is not the sole basis for investment decisions. The correct approach is:

1. Focus on the 15%-25% ROE range, avoiding being misled by excessively high ROE
2. Review at least 5 years of data, to assess whether ROE is steadily improving
3. Combine with other valuation metrics like PE, PB, for comprehensive evaluation
4. Consider industry prospects, to ensure sustainable competitiveness
5. Maintain independent thinking and a good mindset, adhering to your own investment logic

This is the proper way to use ROE for scientific stock selection.