ROE (Return on Equity)

What ROE actually measures

ROE (Return on Equity) measures the return on equity — how much profit the company creates per krona the shareholders have invested. Formula: ROE = Net profit / Equity × 100. ROE is the most complete profitability indicator because it captures three dimensions at once: 1) Operating profitability — can the company generate profit from its operations? 2) Capital efficiency — can the company generate revenue from its assets? 3) Financial leverage — can the company use debt to amplify the return? A company with ROE of 25% creates 25 öre of profit per krona of equity — every year. Over 10 years that becomes 25% × 10 = 250% profit growth, assuming all profit is reinvested. This is compounding — ROE is its engine. Warren Buffett has said: 'We look for companies with ROE above 15% for 5+ years.' This is his primary quality filter. Assa Abloy has ROE ~16% for 10 years — the Buffett requirement met. Electrolux has ROE ~10% — below the requirement. The stock has underperformed.

💡 INSIGHT

ROE captures three dimensions: operating profitability, capital efficiency, and financial leverage. This makes it the most complete profitability indicator — but also the most complex to interpret.

Why ROE is Warren Buffett's favourite

Warren Buffett has for 50+ years emphasized ROE as the most important indicator of company quality. Three reasons. First: ROE captures value creation — a company generating 20% ROE creates a 20% return on shareholders' capital every year, which can be compounded. Second: ROE is hard to fake — it requires both profitability (net profit) and capital discipline (equity). Companies can manipulate a quarterly report, but not 10 years of ROE history. Third: High ROE over time indicates moat — if the company can maintain a high return, they must have something protecting them from competition (otherwise ROE would fall towards the average). Buffett's company Coca-Cola has ROE ~40% for 30+ years — a moat indicator of monumental scale. American Express ~30%. Apple ~150% (after massive share buybacks that reduced equity). See's Candies ~80%. These companies all have one thing in common: pricing power + capital efficiency + low capital reinvestment needs. Swedish equivalents: Assa Abloy ~16%, Atlas Copco ~25%, Hexagon ~20% — all pass the Buffett requirement.

📖 DEFINITION

ROE = Net profit / Equity × 100. Measures the return on shareholders' capital. Buffett requirement: > 15% for 5+ years. AKM1 scale: p3 = 10-15%, p4 = 15-25%, p5 = > 25%.

ROE vs ROA vs ROIC — three return metrics

Three related metrics are often confused. ROE (Return on Equity) = Net profit / Equity. Measures the return on the SHAREHOLDERS' capital, including the effect of debt (financial leverage). ROA (Return on Assets) = Net profit / Total assets. Measures the return on ALL assets (equity + liabilities), removing the leverage effect. ROIC (Return on Invested Capital) = NOPAT / Invested Capital, where NOPAT = net profit + interest rate × (1-tax) and Invested Capital = Equity + interest-bearing debt. ROIC measures the return on ALL invested capital, independent of financing. ROIC is the most 'pure' profitability metric — it shows whether the company's OPERATIONS create value, independent of how it is financed. ROE can be raised through debt (which increases risk); ROIC cannot. A company with ROE of 25% but ROIC of 8% has achieved high ROE through debt — risky. A company with ROE of 15% and ROIC of 15% has achieved ROE through operations — quality. The same ROE, completely different quality. Assa Abloy: ROE 16%, ROIC 13% — leverage but moderate. Sampo: ROE 18%, ROIC 12% — higher leverage.

✓ TIP

Always compare ROE with ROIC. Small difference = quality company (operations-driven ROE). Large difference = indebted company (leverage-driven ROE, more risk). ROE − ROIC = 'spread of leverage' — a measure of financial risk.

⚡ KEY INSIGHTS ROE = Net profit / Equity × 100 — return on shareholders' capital ROE captures three dimensions: operating profitability, capital efficiency, financial leverage Buffett requirement: ROE > 15% for 5+ years indicates moat ROE vs ROIC: large difference = indebted company (risk); small = quality company (operations-driven) 2

The classic DuPont formula

The DuPont decomposition (developed by the DuPont Corporation in the 1920s) breaks ROE into three components: ROE = Net profit margin × Capital turnover × Financial leverage. The formula in detail: ROE = (Net profit / Revenue) × (Revenue / Total assets) × (Total assets / Equity). First component: Net profit margin — how much profit per krona of revenue. Second: Capital turnover — how efficiently the company uses assets to generate revenue. Third: Financial leverage — how much in liabilities the company uses. Three components, three ways to reach ROE of 20%. Company A: (10% × 1,0× × 2,0×) = 20% — profit-driven. Company B: (5% × 2,0× × 2,0×) = 20% — capital-efficiency-driven. Company C: (5% × 1,0× × 4,0×) = 20% — debt-driven. The same ROE, completely different quality. Company A is best — high profit, normal capital turnover, moderate debt. Company C is worst — low profit, low capital turnover, high debt. Company B is in between — volume-driven, like retail. DuPont reveals this — and thus the quality of ROE.

📖 DEFINITION

DuPont formula: ROE = Net profit margin × Capital turnover × Financial leverage. Three components, three ways to reach the same ROE. Reveals the quality of ROE.

Three ways to reach high ROE — three quality levels

Let us analyse three Swedish companies with similar ROE ~18% but different quality. Assa Abloy ROE ~16%: net profit margin ~10%, capital turnover ~1,0×, leverage ~1,6× = 10% × 1,0 × 1,6 = 16%. Driven by profit margin (10% — high for industry) and moderate leverage (1,6× — not extreme). Quality: HIGH — moat through brand + low debt. Sampo ROE ~18%: net profit margin ~22% (insurance has high profit margin because of 'float'), capital turnover ~0,3× (capital-intensive — investments), leverage ~2,7× = 22% × 0,3 × 2,7 = 17,8%. Driven by high profit margin AND high leverage. Quality: MEDIUM — high profit but high debt (typical for insurance). Electrolux ROE ~10%: net profit margin ~3% (low — see the gross margin case), capital turnover ~1,5× (capital-turn-driven), leverage ~2,2× = 3% × 1,5 × 2,2 = 9,9%. Driven by capital turnover and leverage, not profit. Quality: LOW — low profit margin, high debt, moat loss. Roughly the same ROE, three completely different companies. DuPont reveals the difference.

💡 INSIGHT

Three ways to reach ROE 16-18%: profit-driven (Assa Abloy, quality), profit + leverage-driven (Sampo, medium), capital + leverage-driven (Electrolux, low). DuPont reveals which path the company has taken.

The extended 5-step DuPont

⚡ KEY INSIGHTS DuPont formula: ROE = Profit margin × Capital turnover × Financial leverage Three ways to reach ROE 20%: profit-driven (best), capital-driven (in between), debt-driven (worst) Assa Abloy = profit-driven ROE (quality); Sampo = profit+leverage (medium); Electrolux = debt-driven (low) The 5-step DuPont isolates tax and interest effects — reveals 'illusion ROE' 3