In equity investing, Return on Equity (ROE) remains one of the most widely used metrics for assessing a company’s ability to generate profits from shareholders’ funds. While it may seem straightforward, the true power of ROE lies in understanding what drives it, how it varies across industries, and how it should be interpreted in context.
A consistently high ROE is often a hallmark of a well-managed company. It signals that management is effectively using shareholder capital to generate earnings through operational control, strategic decision-making, and efficient capital allocation. Sustained or improving ROE over time generally points to sound financial management, stable profit generation, and the potential to enhance shareholder value.
The Drivers of ROE – Insights from the DuPont Model
To understand why a company’s ROE is high or low, investors often turn to the DuPont model, which breaks ROE into three components: operational efficiency (profit margins), asset utilisation (asset turnover), and financial leverage (equity multiplier). This helps investors pinpoint whether changes in ROE stem from stronger profits, better use of assets, or increased debt. Another useful concept is the sustainable growth rate, which is the pace at which a company can grow without needing extra equity or debt.
Together, these tools allow for a deeper evaluation of whether a high ROE is sustainable or driven by short-term factors.
High vs Low ROE Industries
Different industries possess diverse capital structures and asset intensities, so a "good' ROE in one sector may be considered average or low in another. For instance, utility companies typically exhibit ROEs around 10%, whereas technology firms may surpass 18%, owing to lower capital requirements. Industries characterised by high ROE, such as software, financial services, branded consumer goods, and specialised manufacturing, tend to exhibit high profit margins and/or require minimal capital investment. Conversely, capital-intensive or heavily regulated industries, such as utilities, telecommunications, food production, and traditional manufacturing, generally exhibit lower ROE.
It is important to compare companies against their industry peers, rather than a universal benchmark.
Why ROE Alone is Not Enough
While ROE is valuable, it should never be the sole basis for investment decisions. Pairing it with complementary metrics provides a more rounded view of a company’s health. Metrics like Return on Assets (ROA), Debt-to-Equity (D/E) ratio, Return on Capital Employed (ROCE), Economic Value Added (EVA), profit margins, asset turnover, Return on Invested Capital (ROIC), Earnings Per Share (EPS) growth, and growth rate provide a comprehensive understanding of a company’s profitability, efficiency, leverage, and risk profile.
By integrating these measures, investors can identify companies that not only generate strong returns for shareholders but also do so in a sustainable, efficient, and low-risk manner.
Final Thoughts
ROE remains a cornerstone of equity analysis, but context is crucial. By examining its drivers, comparing within industry norms, and pairing it with complementary indicators, investors can better identify companies with genuine long-term value creation potential.
