ROE and ROA — How Well It Earns
Even earning the same profit of about $740,000, a company that earned it by managing about $740,000 and one that managed about $7.4M have different skill. What measures this 'efficiency' is ROE and ROA.
ROE and ROA, What's the Difference?
Both are profitability metrics that show 'how efficiently profit is generated.' The numerator is the same and the denominator differs.
- ROE (Return on Equity) = net income ÷ shareholders' equity - ROA (Return on Assets) = net income ÷ total assets
ROE looks at how much was earned with 'the money shareholders put in (equity),' while ROA looks at how much was earned with 'total assets, including debt.'
For example, if net income is about $7.4M and equity is about $37M, ROE is 20%. It means 'earned $20 for every $100 of shareholders' money.' The higher the number, the better the efficiency is considered.
The Trap of High ROE: It Can Rise via Debt Too
You mustn't conclude that a high ROE unconditionally means a good company. That's because ROE can be raised by increasing debt (leverage) too.
What shows this well is 'DuPont analysis' (devised by the U.S. company DuPont in the 1920s). It's a method of breaking ROE into three pieces.
ROE = net profit margin × asset turnover × financial leverage (total assets ÷ equity)
The last piece, 'financial leverage,' grows the more debt there is. In other words, even if the core-business ability (the first two pieces) stays the same, simply increasing debt can make ROE appear to rise. So when you see a high ROE, you have to check 'is ROA also high, or is it thanks to debt?'
If ROE is high but ROA is low, that high ROE likely came in large part from debt (leverage). Debt turns into a risk when the economy sours, so you have to look at them together.
How Best to Use Them
ROE and ROA are useful when viewed like this.
① Look at whether it's 'consistently' high over several years (a single year's spike could be a one-off). ② Compare within the same industry (industries that use a lot of capital inherently have low ROA). ③ Look at ROE and ROA together to check 'does it earn well even without debt?'
This is exactly why investors like Warren Buffett frequently cite 'consistently high ROE' as a signal of a good business. That said, this too is just one reference metric, and deciding to buy on this number alone is dangerous.
Preguntas frecuentes
Q. Above what percent is a good ROE?
It varies by industry and era, but many hold the view that 'consistently above 15% over a long period' is a good signal. However, it's not an absolute standard. Capital-heavy heavy industry and light software companies have different normal ranges, so comparing within the same industry is the right approach.
Q. Why does ROA come out lower than ROE?
Because ROA's denominator is 'total assets, including debt,' the denominator is larger. Since most companies use some debt, ROE comes out higher than ROA. The larger that gap, the more it means the company is using a lot of debt (leverage).
Páginas relacionadas
📋 Los resultados se basan en datos históricos; las rentabilidades pasadas no garantizan rentabilidades futuras.
📋 Este servicio se ofrece con fines educativos para ayudarte a entender la inversión, no como asesoramiento de inversión.