Return on Equity and the Debt That Can Inflate It

A return on equity of 30% can come from a superb business. It can also come from an ordinary one carrying a lot of debt, and the ratio alone will not tell you which. Splitting it into parts will.

The basic calculation

Profit goes on top, equity underneath. Because equity moves during the year as profit is retained, dividends are paid and shares are bought back, most careful versions divide by the average of the opening and closing figures. Some tools use year-end equity alone. When equity is changing fast, the gap gets wide.

Three parts: the DuPont breakdown

ROE is the product of three ratios, known as the DuPont breakdown. Net margin says how much profit each dollar of sales produces. Asset turnover says how many dollars of sales each dollar of assets generates. The equity multiplier, total assets divided by equity, says how much of those assets are funded by shareholders and how much by everyone else, mostly lenders. A discount grocer and a luxury brand can land on the same ROE by opposite routes, the grocer through thin margins and fast turnover, the luxury brand through fat margins on a slower-moving stock of goods.

The first two factors describe the business. The third describes the financing. A rising ROE driven by margin or turnover is an operating improvement, while a rising ROE driven by the multiplier means the company is running on more borrowed money.

Same business, more debt

Company B is a hypothetical twin of Company A, with the same revenue, assets and operations. Only the funding differs. B used $500M more debt and $500M less equity. The extra borrowing costs interest, which after tax cuts net income by $15M.

ROE jumps from 12% to 21%. Nothing about the products, customers or costs has changed. What changed is that Company B now has to meet larger interest payments whatever happens to sales, and if revenue falls, its profit and its ROE will fall much faster than Company A’s. A screen that ranks on ROE alone would put B ahead anyway. Check debt-to-equity before trusting the ranking.

Buybacks and negative equity

Buybacks work on the same denominator. Every dollar spent repurchasing stock removes a dollar of equity, so a company that returns most of its profit through buybacks year after year will report a steadily rising ROE even when net income is flat. A company that spends more on buybacks over the years than it ever retained drives its equity below zero. At that point ROE is meaningless. A positive profit divided by negative equity gives a negative ROE, and a loss divided by negative equity gives a positive one, so most tools show NM or leave the field empty. The same distortion shows up as a sky-high or negative price-to-book ratio.

Compare it with ROIC

Return on invested capital puts debt and equity together in the denominator and uses operating profit after tax on top, so moving money between borrowing and shares barely changes it. Put the two side by side. If ROE is high and ROIC is ordinary, the gap is financing. If both are high, the business itself is earning well on its capital. For Company A and Company B, ROIC would come out nearly identical, which is the correct answer for two businesses that differ only in how they are funded.

Where to find it and how to use it

Quote pages usually list ROE in the statistics or profitability section, often labeled TTM. Screeners carry it as a filter. A single year’s ROE can be bent by a one-off gain or charge in net income, so a figure that leaps for one year and falls back the next usually has its explanation sitting in the income statement. Tools differ on average versus ending equity and on whether the net income figure is reported or adjusted, so the same company can show different ROE on different platforms.

ROE is a standard yardstick for banks and insurers, where equity is the regulatory cushion and the balance sheet is close to market value. For other businesses, use it with its breakdown. Look at several years instead of one, compare with close peers, run the DuPont split whenever ROE looks unusually high, and check the equity multiplier and the debt load before treating a high reading as evidence of a great business, because the multiplier is the one factor a management team can raise quickly without making the company any better at what it does.