Profitability
Return on Equity (ROE)
ROE measures how much profit the company generates for each dollar of shareholder equity.
Return on equity is the classic quality ratio. A business that earns 20% on equity can compound book value quickly if it retains the profit. A business that earns 5% will not, no matter how cheap the P/E looks, unless the price is a deep discount to a real asset value.
Debt boosts ROE. Borrowed money shrinks the equity denominator, so a leveraged firm can post a glamorous ROE on ordinary operating returns. Read ROE next to ROIC and debt-to-equity. If ROE is high and ROIC is ordinary, the leverage is the trick. Banks are the exception in presentation: for a bank, equity returns are the right lens because the balance sheet is the business.
Formula
ROE = net income ÷ average shareholders' equity
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Questions
What ROE is high quality?
Mid-teens or better, sustained, without a dangerous debt load, is the usual quality screen. A single year above 30% can be a gain on sale.
Why use average equity?
Profit is earned across the year. Ending equity alone misstates the base if the company issued or repurchased stock.