What is ROE?
ROE equals net income divided by average shareholders' equity, expressed as a percentage. If a company earns $500 million on $2.5 billion in equity, its ROE is 20%. This means the company generates $0.20 of profit for every $1.00 of shareholder investment. The median ROE for S&P 500 companies is approximately 15-18%, though it varies widely by industry - software companies often exceed 30% while utilities average 8-10%.
DuPont Analysis
The DuPont framework decomposes ROE into three components: profit margin, asset turnover, and financial leverage. A company with 10% profit margin, 1.5x asset turnover, and 2.0x leverage has an ROE of 30%. This breakdown reveals whether high ROE comes from operational efficiency (desirable) or excessive debt (risky). Two companies with identical 25% ROE may have very different risk profiles if one achieves it through margins and the other through leverage.
Key Considerations
High ROE driven by heavy debt is less sustainable than high ROE from strong margins. Companies that aggressively buy back shares reduce equity, mechanically inflating ROE without improving operations. Warren Buffett targets companies with consistently high ROE above 15% over 10+ years as a sign of durable competitive advantage. Compare ROE within the same industry, as capital-light businesses like software naturally have higher ROE than capital-intensive sectors like manufacturing.