Return on equity

Return on equity is net income divided by shareholders equity: for every dollar owners have in the business, how many cents did it earn this year. It is the closest single number to the question of whether this is a good business, which is why it appears on almost every screen.

Sustained high returns on equity are rare and usually indicate something durable, such as a brand, a network, a licence or a cost position competitors cannot match. Businesses without such an advantage tend to see returns compete back down toward the cost of capital.

Equity is the denominator, and borrowing shrinks it. A company can raise its return on equity simply by funding itself with more debt and less owner capital, without the underlying operation improving at all, and the ratio will look better precisely as the business becomes more fragile.

This is the single most important caveat. Two companies at 25% can be a superb operation carrying no debt and a mediocre one carrying a great deal, and ROE alone cannot distinguish them. Return on invested capital, which counts debt and equity together, is the version not fooled by capital structure, and comparing the two is usually more informative than either alone.

Years of buybacks can reduce book equity to very little, which sends ROE to spectacular levels that say more about accounting than performance. Taken far enough equity turns negative, and the ratio becomes meaningless rather than merely flattering, since a negative denominator produces a negative ROE for a profitable company.

Equity is also a historical figure: it records what was contributed and retained, not what the assets are worth now. A company whose value sits in brands or research it has expensed rather than capitalised will show a small equity base and a high return, which is a statement about accounting conventions as much as about the business.

Consistency matters more than the peak. A decade in the high teens through a downturn is stronger evidence than a single year at 40%, which is often a cyclical high or a one-off gain.

And it is not comparable across industries. Banks run structurally high leverage by design and are not measured against the same yardstick as a software company. As with most ratios, comparison is only meaningful within a sector, against the same company own history, or both.