Why should you look at ROE when investing in stocks? Analyzing the key role of Return on Equity in stock selection

Buffett’s Stock Picking Secret: Why ROE Is So Important

The stock market legend Warren Buffett has publicly stated that if he could only use one indicator to select stocks, he would choose ROE without hesitation. Companies that can maintain a stable ROE above 20% over the long term are often good investment targets. This statement reveals the core importance of ROE in value investing.

Many investors, when first encountering ROE, tend to fall into a misconception: believing that higher ROE is always better. However, this understanding is one-sided. To truly utilize ROE for stock selection, one must first understand its fundamental meaning and its relationship with other financial indicators.

What Does ROE Actually Measure?

ROE stands for Return on Equity, also known as Shareholders’ Equity Return, Net Asset Return, or Equity Profitability. Simply put, it measures how much profit a company can earn with the capital invested by shareholders.

From an asset structure perspective, a company’s funding sources are divided into two parts: one is the equity directly invested by shareholders and retained earnings; the other is borrowed funds through debt financing. Moderate use of financial leverage can improve capital efficiency, but excessive debt increases risk. ROE is an important indicator of how efficiently a company uses its own capital.

For example, Company A has net assets of 1,000 yuan and an 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, with an ROE of 5%. Although Company B has a higher total profit, Company A is more efficient in utilizing its capital. This illustrates the core value of ROE.

How to Calculate ROE

Basic formula: ROE = Net Profit ÷ Net Assets

where, Net Profit = After-tax profit + Profit distribution; Net Assets = Owner’s equity + Minority shareholders’ equity.

In practical stock market applications, the calculation becomes more complex. It requires using a weighted average return on net assets formula to account for changes in net assets throughout the year. Specifically, it involves starting with the net assets at the beginning of the reporting period, adding new net assets issued during the year (such as new stock issuance or debt-to-equity swaps) weighted monthly, and subtracting reductions in net assets (such as buybacks or dividends) weighted monthly.

This indicator is more valuable than simply earnings per share because it eliminates misleading effects caused by corporate actions like issuing red shares. Some companies distribute bonus shares, which can lower EPS, but this does not necessarily mean a decline in profitability. ROE can more accurately reflect the actual situation.

The Difference Between ROE, ROA, and ROI

In financial analysis, three similar indicators are often seen and easily confused:

ROA (Return on Assets)

Full name: Total Asset Return Rate, used to measure how much net profit is generated per unit of assets. The formula is: ROA = Net Income ÷ Total Assets. This indicator assesses management’s ability to generate profit using all assets (including debt-financed assets), covering a broader scope.

ROI (Return on Investment)

Full name: Return on Investment, refers to the economic return obtained from investment activities. The formula is: ROI = Annual profit or average annual profit ÷ Total investment × 100%.

ROI is simple and intuitive to calculate but does not consider the time value of money and cannot fully reflect the actual status of investment projects. Moreover, ROI is often time-sensitive, based on data from a specific year.

The fundamental difference among the three is: ROE measures the return on shareholders’ equity, ROA measures the return on total assets, and ROI measures the return on invested capital. Investors need to analyze these indicators comprehensively when evaluating a company.

High ROE Doesn’t Always Mean Good: Understanding Market Valuation Truths

Many novice investors rush to buy stocks with very high ROE, unaware that there may be hidden investment traps behind it.

Looking at the essence of ROE from another angle: ROE = Net Profit ÷ Net Assets, which can be transformed into ROE = (Market Cap ÷ Net Assets) ÷ (Market Cap ÷ Net Profit) = PB ÷ PE.

This formula reveals a key truth: the level of ROE depends on the ratio of PB (Price-to-Book ratio) to PE (Price-to-Earnings ratio). For investors, low PE and low PB are more attractive because they imply lower purchase risk. Currently, the market generally considers PE in the 20-30 times range to be reasonable.

Assuming PE remains relatively stable, increasing ROE requires PB to rise as well. But a very high PB indicates potential bubbles. In other words, extremely high ROE driven by low PE and high PB is often unsustainable.

Historical data shows that stocks maintaining a long-term ROE of 15% are rare. A stock with a PE of 10 and a PB of 2 can reach a 20% ROE; with a PE of 10 and a PB of 5, ROE can reach 50%. These figures are very difficult to sustain.

When ROE is excessively high, it also attracts more capital inflow into the industry, intensifying competition. If the company’s core competitiveness is lacking, it can be easily disrupted by new entrants. Moreover, increasing ROE becomes progressively more difficult—rising from 2% to 4% is relatively easy, but from 20% to 40% is much harder, because the industry environment at high base differs significantly from that at low base.

How to Use ROE Effectively for Stock Selection

Based on the above analysis, investors should adopt a cautious attitude when using ROE for stock selection:

Time horizon should be sufficiently long

Don’t rely solely on ROE data from a single year. Focus on at least the past 5 years. While historical data cannot predict the future, it clearly reflects whether the company’s profitability has been steadily improving.

Reasonable ROE range

It is recommended to consider ROE between 15% and 25% as a reference standard. This range avoids the risks associated with too low ROE (insufficient capital efficiency) and too high ROE (potential bubbles).

Pay attention to trends, not just absolute values

A consistently rising ROE trend is most worth noting, indicating improving management quality. Conversely, even if ROE is not low, a declining trend should be approached with caution.

Combine with other indicators

ROE is an important reference for stock selection but not the sole criterion. It should be combined with PE, PB, net profit growth, cash flow, and other multi-dimensional indicators to make more rational investment decisions.

Tools and Methods to Check ROE in Real Time

Investors who want to quickly check the ROE of specific stocks can use free platforms like Google Finance, Yahoo Finance. To screen for stocks with high ROE rankings, visit professional stock screening websites and set filters based on market and ROE parameters.

Major Global Markets’ ROE Rankings at a Glance

Data as of August 2023:

Top ROE Stocks in Taiwan Stock Market (partial)

Top ROE Stocks in US Market (partial)

Top ROE Stocks in Hong Kong Market (partial)

Summary: The Correct Approach to ROE Stock Selection

ROE is undoubtedly a key indicator for investors to evaluate company quality, but success depends on proper understanding. Remember: ROE is not always better the higher it is. A stable level of 15%-25% combined with a continuously rising trend is far more valuable than a single-year high figure.

The true investment path lies in independent thinking, sticking to your own profit model, observing long-term ROE trends, and combining valuation indicators like PE and PB for comprehensive judgment. Maintaining a good mindset and supporting decisions with multiple data dimensions is the right way to achieve steady investment returns.