Owners hand a business their money and leave much of its profit inside it. A natural question follows: how well is that money being used?
Return on shareholders’ equity, usually shortened to return on equity or ROE, is the standard answer. It is net earnings divided by shareholders’ equity. A business that earns $20 million on $100 million of equity has an ROE of 20%.
Warren Buffett and the Interpretation of Financial Statements treats ROE as one of the key signals Buffett relies on, and it also spends time on the ways the number can mislead. This article explains how to calculate and read ROE, breaks it into its parts, shows how debt and buybacks can flatter it, and draws out what the idea means for founders deciding how to use their own capital.
Calculating return on equity
The formula is straightforward:
Return on equity = Net earnings ÷ Shareholders’ equity
Net earnings come from the bottom of the income statement. Shareholders’ equity comes from the balance sheet: total assets minus total liabilities, or equivalently the money owners have contributed plus the profits the business has retained.
Because equity changes during the year, some analysts use the average of opening and closing equity. For a stable business the difference is small; for one that raised capital or made large distributions during the year, it can matter. Whichever method you choose, use it consistently.
What a high return on equity tells you
According to the book, businesses with a durable competitive advantage consistently show higher-than-average returns on equity, while businesses in intensely competitive industries show low or erratic ones.
This makes sense. A business with an advantage can earn well on every dollar it keeps, so as retained earnings accumulate, earnings rise with them. Over time the underlying value of the business compounds. A business without an advantage struggles to earn much on its capital, and its retained profits produce little additional earning power.
The book’s shorthand is blunt: high returns on equity are an invitation to look closer, and low returns are a reason to stay away.
Why ROE and retained earnings belong together
ROE is the rate at which retained profits compound. A business earning 20% on equity and retaining its profits grows its equity, and potentially its earnings, by around 20% a year. One earning 8% grows at around 8%. Over a decade, that difference produces businesses of very different sizes, as the article on retained earnings illustrates. ROE is therefore not just a measure of past performance but a rough indicator of how fast a business can grow from its own resources.
Breaking ROE into its parts
A useful way to understand ROE is to split it into three components, an approach often called the DuPont analysis:
ROE = Net margin × Asset turnover × Equity multiplier
- Net margin (net earnings ÷ revenue) measures how much profit each sales dollar produces.
- Asset turnover (revenue ÷ total assets) measures how hard the assets work.
- Equity multiplier (total assets ÷ equity) measures how much of the business is funded by debt and other liabilities rather than by owners.
Multiply the three together and the revenue and assets cancel out, leaving net earnings divided by equity.
The value of the split is that two businesses with identical ROE can be very different underneath.
| Business A | Business B | |
|---|---|---|
| Net margin | 10% | 4% |
| Asset turnover | 1.5 | 1.25 |
| Equity multiplier | 1.33 | 4.0 |
| Return on equity | 20% | 20% |
Business A earns its 20% through strong margins and efficient assets, with modest borrowing. Business B earns the same 20% with thin margins, propped up by an equity multiplier of 4, meaning three-quarters of its assets are funded by liabilities. A’s return reflects the business. B’s return reflects the financing.
The book’s preference is clear: a high ROE built on margins and efficiency suggests a durable advantage; a high ROE built on leverage suggests something more fragile.
How leverage can flatter the number
ROE measures the return on the owners’ money, not on all the money in the business. If a company borrows heavily, it can earn a strong return on equity simply because there is very little equity relative to the debt.
Here is an illustration. Two businesses each have $100 million of assets earning an operating return of 10%, or $10 million a year. For simplicity, ignore tax.
| Business A (no debt) | Business B (heavily borrowed) | |
|---|---|---|
| Assets | $100m | $100m |
| Debt (at 6%) | $0 | $80m |
| Equity | $100m | $20m |
| Operating profit | $10.0m | $10.0m |
| Interest | $0 | $4.8m |
| Net earnings | $10.0m | $5.2m |
| Return on equity | 10% | 26% |
The underlying businesses are identical. Business B’s ROE is more than two and a half times higher purely because of its financing.
Now suppose a bad year cuts the operating return to 4%, or $4 million. Business A earns $4 million, an ROE of 4%. Business B earns $4 million minus $4.8 million of interest, a loss of $0.8 million and a negative ROE. The same leverage that inflated the return in good years produces losses in bad ones.
The book warns that this kind of financial engineering can make an ordinary business look exceptional, and that it is fragile. If interest rates rise or the investments earn less than expected, leverage can wipe out the equity.
Banks and financial companies are the clearest case. They are highly leveraged by design, so their ROE needs to be read with that in mind and compared only with similar institutions.
Measures that look past leverage
Because ROE can be flattered by debt, analysts often look at related measures alongside it:
- Return on assets (ROA): net earnings ÷ total assets. It shows how well all the assets are used, regardless of how they are funded.
- Return on capital employed (ROCE): operating profit ÷ (equity plus long-term debt). It measures the return on all long-term capital before financing costs.
A business with high ROE and high ROCE is earning well on all its capital. A business with high ROE but modest ROCE is probably relying on leverage. Comparing the measures takes only a few minutes and often clarifies the picture.
How buybacks affect the figure
Share buybacks also reduce equity, because the company is paying cash back to some owners. Lower equity raises ROE even if earnings are unchanged.
The book suggests a way to see through this: add the value of repurchased shares (shown as treasury stock in the United States; in Australia bought-back shares are generally cancelled, reducing share capital) back into equity before calculating ROE. If the business still shows a strong return, the result reflects genuine economics rather than balance-sheet arithmetic.
A note on negative equity
Occasionally a company shows negative shareholders’ equity. The book notes two very different reasons. Some exceptionally profitable companies pay out so much in dividends and buybacks that their equity falls below zero. Struggling companies reach the same place through accumulated losses. The way to tell them apart is the earnings history: years of strong profits suggest the first case, years of losses the second. In either case the ROE figure itself becomes meaningless, and the earnings history must do the work instead.
What changes in ROE tell you
The direction of ROE over time is often more revealing than its level.
Steady high ROE with steady low debt is the pattern the book looks for. It suggests a business that earns well on each new dollar it retains, year after year.
Rising ROE can be good news, but it is worth asking why. If margins or asset efficiency are improving, the business is getting stronger. If debt is rising or equity is shrinking through buybacks or losses, the improvement may be arithmetic rather than economics.
Falling ROE while retained earnings grow is a common pattern in businesses that have outgrown their best opportunities. The original business may still earn well, but new capital is going into projects that earn less. Mature businesses in this position often do better by distributing more of their profits.
Volatile ROE usually reflects volatile earnings, which suggests a business exposed to cycles, commodity prices or intense competition.
A ten-year table of ROE, alongside net margin, asset turnover, equity multiplier and debt, shows which of these patterns applies. It takes little time to build from annual reports and often tells the story at a glance.
Reading ROE well
Taken together, the book’s approach suggests a few rules:
- Look at ROE over many years, not one.
- Compare it with debt levels. A high ROE with low debt is far more meaningful than a high ROE built on borrowing.
- Break it into margin, turnover and leverage to see where it comes from.
- Adjust for buybacks if they are large.
- Check that rising ROE comes with rising earnings, not just shrinking equity.
- Compare with direct competitors, since normal returns differ by industry.
ROE in a small business
For a small company, ROE can be calculated from the annual accounts in the same way. Two adjustments make it more meaningful.
Pay the owner a market wage first. Many owner-operators pay themselves little or nothing, leaving the value of their work in the business’s profit. That inflates both profit and ROE. Before calculating, subtract what it would cost to employ someone to do the owner’s job. The remaining return is what the capital genuinely earns.
Compare with the alternative. The capital in a small business could be earning a return elsewhere: in an offset account, a term deposit or diversified investments. An ROE that is only slightly above those alternatives may not compensate for the extra risk and effort of running a business.
Illustratively, an owner with $300,000 of capital in a business reporting $90,000 of profit might see an ROE of 30%. If a market wage for the owner’s role is $75,000, the true return on capital is $15,000, or 5%. That changes the conversation about whether to expand, sell or restructure.
What this means for founders
Founders can apply the same thinking to their own capital decisions. The question is not just “will this make a profit?” but “what return will it make on the money we put in, without borrowing to dress it up?”
A few principles follow:
- Design for returns from margin and efficiency. These are durable. Returns from leverage are not.
- Use capital sparingly. A business that needs little capital to earn its profit has a naturally high ROE and more freedom.
- Borrow to amplify a proven return, not to create one. If the business earns well on its own capital, modest debt can help. If it does not, debt makes things worse.
- Track ROE as you grow. A falling ROE during expansion can signal that new capital is earning less than the original business.
A business that earns strong returns on modest capital has freedom. One that only looks profitable because of debt has a dependency.
Common mistakes
Reading ROE without checking debt. Leverage can manufacture high returns.
Ignoring buybacks. Shrinking equity lifts ROE without improving the business.
Comparing across industries. Normal returns differ widely between, say, software and utilities.
Forgetting the owner’s wage. In small businesses, it can be most of the “return”.
Judging one year. Consistency matters as much here as anywhere.
Questions to ask
- What has ROE been over the last ten years, and how stable is it?
- How much of it comes from margin, how much from asset efficiency and how much from leverage?
- What does ROCE or ROA show by comparison?
- Have buybacks reduced equity materially?
- For your own business: after paying yourself a fair wage, what return is your capital really earning?
Bringing it together
Return on equity shows how well a business uses its owners’ money, and consistently high returns are one of the strongest signs of a durable advantage. But the measure is easy to flatter. Debt, buybacks and unpaid owner labour can all make an ordinary return look exceptional.
Reading ROE well means asking where the return comes from. When it comes from strong margins and efficient use of assets, it is evidence of something lasting. When it comes from leverage, it is evidence mostly of risk.
Source: Mary Buffett and David Clark, Warren Buffett and the Interpretation of Financial Statements (2008). Figures in this article are illustrations, not data. This article is general information, not financial or investment advice.
