Return on Equity (ROE) vs ROIC: Which Measure Should You Trust?
Return on equity (ROE) measures the profit a company earns on the shareholders' money alone: ROE = net income ÷ shareholders' equity. It is useful, but debt, buybacks and write-downs can push it up without the business getting any better, so for judging business quality you should trust ROIC first and use ROE as a cross-check.
ROE is the return metric most investors meet first. It is on every stock screener and in most annual reports. Knowing exactly when it tells the truth, and when it flatters, will save you from mistaking a heavily borrowed business for a great one.
Where this fits: this article supports Criterion 1, "Is it a great business?", in the Five Criteria framework. The full case for ROIC as our headline measure is in the ROIC hub; here we focus on ROE and how the two compare.
What Is Return on Equity?
Return on equity tells you how much profit the company generated for each dollar of book value that shareholders own. If a company has $500 million of equity and earns $75 million of net income, its ROE is 15%.
The ROE formula
ROE = Net income ÷ Shareholders' equity × 100
Net income comes from the bottom of the income statement. Shareholders' equity comes from the balance sheet. Many analysts use average equity across the year, which is more accurate when equity changes a lot.
Why investors like ROE
ROE has a real logic behind it. Equity is the owners' money, and net income is the profit that belongs to owners. So ROE asks a sensible owner's question: what return am I earning on the capital I have left in this business?
Warren Buffett leaned on this idea early on. In his 1979 letter to Berkshire Hathaway shareholders he wrote that "the primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share."
Read that quote closely. The words in brackets matter as much as the rest. Buffett was already warning that ROE is only meaningful when debt and accounting tricks are not doing the work.
ROE vs ROIC: The Key Difference
The difference is the denominator. ROE divides by equity only. ROIC divides by all the capital in the business, both equity and debt, less spare cash.
Feature | ROE | ROIC |
Profit measure | Net income (after interest) | NOPAT (before interest, after tax) |
Capital measure | Shareholders' equity | Equity + debt − cash |
Affected by borrowing? | Yes, heavily | Largely no |
Best for | Banks, insurers, owner's view | Judging the operating business |
Because ROE ignores debt in the denominator, a company can raise its ROE simply by borrowing money and using it to shrink equity. The business underneath does not have to change at all. ROIC includes the debt, so the same move leaves it roughly unchanged.
We explain how to calculate ROIC step by step in the ROIC hub, so we will not repeat it here.
Worked Example: Same Business, Three Balance Sheets
Imagine three hypothetical companies that own identical businesses. Each earns $100 million of operating profit on $500 million of invested capital and pays 25% tax. The only difference is how they are financed.
Company A has no debt. All $500 million is equity.
Company B borrowed $300 million at 5% and returned it to shareholders, so equity is $200 million.
Company C borrowed $550 million at 5% and bought back so many shares that equity is now negative $50 million.
Line item | Company A | Company B | Company C |
Operating profit | $100m | $100m | $100m |
Interest (5%) | $0m | $15m | $27.5m |
Net income | $75m | $63.75m | $54.4m |
Equity | $500m | $200m | −$50m |
Debt | $0m | $300m | $550m |
ROE | 15.0% | 31.9% | Not meaningful |
ROIC | 15.0% | 15.0% | 15.0% |
Company B's ROE is more than double Company A's. A screener would rank it as the far better business. Yet it is the same business with more debt, less profit and more risk.
Company C shows the extreme case. Its equity is negative, so ROE is meaningless. Some screeners show a huge negative number, others show nothing, and a few show a huge positive one. ROIC, meanwhile, still reads 15% for all three, because the operations have not changed.
That is the whole argument in one table. ROIC tells you about the business. ROE tells you about the business plus the financing.
Breaking ROE Apart: The DuPont Formula
A useful way to see what drives ROE is the DuPont formula, which splits it into three parts:
ROE = Net margin × Asset turnover × Equity multiplier
Net margin = Net income ÷ Revenue. How much profit each sale produces.
Asset turnover = Revenue ÷ Total assets. How hard the assets work.
Equity multiplier = Total assets ÷ Equity. How much of the assets are funded by debt and other liabilities.
Multiply the three together and revenue and assets cancel out, leaving net income ÷ equity.
Two routes to the same ROE
DuPont part | Company D | Company E |
Net margin | 15% | 5% |
Asset turnover | 1.0x | 1.0x |
Equity multiplier | 1.33x | 4.0x |
ROE | 20% | 20% |
Both companies report a 20% ROE. Company D gets there through a strong margin and modest leverage. Company E gets there with a thin margin and assets funded four times over by liabilities.
The first is a quality business. The second may be fine in good times, but a small fall in margin could wipe out a large slice of its equity. DuPont shows you which kind you are looking at in about two minutes.
What Else Distorts ROE?
Debt is the biggest distortion, but not the only one.
Buybacks. Buying back shares reduces equity. If the price paid is well above book value, equity can shrink fast, lifting ROE even when profit is flat. Our guide to stock buybacks explains when that is good capital allocation and when it is not.
Write-downs. A large goodwill or asset write-off cuts equity in one go. ROE then looks better in later years, simply because the denominator got smaller.
Losses. Years of losses shrink equity, so a modest recovery can produce an eye-catching ROE.
Idle cash. A company holding a large cash pile has a higher equity base and a lower ROE than its operations deserve. ROIC removes that cash.
One-off gains. A property sale or tax credit lifts net income for a year and inflates ROE with it.
Sector Caveats: When ROE Is the Right Tool
Banks and insurers
For banks and insurers, ROE is usually the better measure. Borrowed money, such as deposits or insurance premiums held before claims are paid, is the raw material of the business rather than a financing choice. Separating operating capital from debt, as ROIC does, stops making sense.
For these companies, investors typically look at ROE or return on tangible equity through a full credit or underwriting cycle, alongside price-to-book. Our case study on Buffett and Bank of America shows this kind of analysis in practice. These are sector exceptions; they do not change the house default for everyone else.
Capital-light businesses with negative equity
Some excellent businesses, often franchisors and asset-light brand owners, have returned so much cash that their equity is small or negative. ROE becomes useless for them. Judge them on ROIC, free cash flow and the debt tests in our guide to how much debt is too much.
Utilities and other regulated businesses
Regulators often set allowed returns with reference to equity, so ROE is part of how these businesses are discussed. Even here, compare ROE with ROIC so you can see how much of the return comes from leverage.
How We Use This in the Five Criteria
The house test for Criterion 1 uses ROIC, not ROE: ROIC of 15% or more for at least five years, with a stable or rising gross margin and free cash flow of at least 90% of net income.
ROE still earns a place as a cross-check. In practice I use it in three ways:
Compare ROE with ROIC. If they are close, the return comes from the business. If ROE is far higher, debt or buybacks are doing a lot of the work.
Run DuPont when ROE looks high. Find out whether the driver is margin, turnover or leverage.
Send leverage-driven ROE to Criterion 4. A big gap between ROE and ROIC is a prompt to test net debt/EBITDA (house maximum 2.0x) and interest coverage (house minimum 5x).
Having worked in investor relations, I have seen how often ROE is presented as the headline return in company materials. There is nothing wrong with that, but it is always worth asking what the same business would earn without the debt. ROIC answers that question.
Common Mistakes With Return on Equity
Ranking companies on ROE alone. It rewards leverage. Always check ROIC alongside it.
Trusting ROE when equity is tiny or negative. The ratio breaks down. Switch to ROIC and cash flow.
Ignoring why equity changed. Buybacks, write-downs and past losses all shrink equity and flatter ROE.
Using a single year. One-off gains or losses swing net income. Use a five-year average.
Applying ROIC to a bank. For financial companies, ROE and return on tangible equity are the better tools.
Forgetting Buffett's brackets. High ROE counts only "without undue leverage, accounting gimmickry, etc."
Frequently Asked Questions
What is a good return on equity? Many investors treat a sustained ROE of 15% or more as strong, but the number means little on its own. Check that ROIC is also high and that debt is modest; a high ROE built on borrowing is not a sign of quality.
Why can ROE be higher than ROIC? When a company uses debt that costs less than its return on capital, the extra profit goes to a smaller equity base, so ROE rises above ROIC. The bigger the gap, the more the return depends on leverage.
What does negative return on equity mean? It means either the company lost money or its equity is negative. The second case often comes from heavy buybacks or past losses, and the ratio is then meaningless, so use ROIC and free cash flow instead.
Is ROE or ROIC better for bank stocks? ROE is usually better for banks and insurers, because borrowed money is part of their operations. For almost every other business, ROIC gives the more honest picture.
Your Next Step
Look up ROE and ROIC for three companies you follow and note the gap between them. Then read the ROIC hub for the full calculation, and check any company with a large gap against the debt tests in long-term debt explained. To score a company on all five tests, use the Five Criteria Checklist.
About the author: Cameron Hayes is a senior investor relations and finance professional who has worked in IR at Nasdaq Copenhagen-listed companies including Nilfisk and Maersk Drilling. He holds an MSc from Copenhagen Business School and a BCom from the University of Ottawa, and founded Gingernomics to teach individual investors the Five Criteria framework. More about Gingernomics.
The content on Gingernomics is for educational and informational purposes only and does not constitute financial advice. Always do your own research and consult a licensed financial advisor before making any investment decisions. Past performance is not indicative of future results.
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