The Ultimate Guide to ROE Stock Selection: Understanding and Applying Return on Equity (ROE) in Practice

Why Are Investors Focusing on This Indicator?

Many retail investors feel clueless when choosing stocks. In fact, Warren Buffett has already revealed the key—if you can only use one indicator to select stocks, it’s Return on Equity (ROE). Companies that can maintain an ROE above 20% for years are often high-quality investment targets. However, this seemingly simple number often carries misunderstood logic behind it.

The Meaning of ROE in Chinese: More Than Just a Simple Return

Return on Equity (ROE) is a core metric measuring how effectively a company uses shareholders’ equity. It reflects: for every dollar invested by shareholders, how much net profit the company can earn.

Understanding ROE from another perspective—it’s the percentage of after-tax profit relative to average shareholders’ equity. The formula appears simple: ROE = Net Profit ÷ Net Assets

But the actual composition involves two sources of funds:

1. Shareholders’ direct investments — including share capital, statutory reserves, retained earnings, and all owner’s equity
2. Borrowed funds — using appropriate financial leverage to improve capital efficiency, but excessive debt increases risk

A higher ROE indicates a stronger ability of the company to generate returns from its own capital.

Three Levels of ROE Calculation

Basic Version: ROE = After-tax Profit ÷ Shareholders’ Equity

For example: Company A has net assets of 1,000 yuan and after-tax profit of 200 yuan, ROE is 20%; Company B has net assets of 10,000 yuan and after-tax profit of 500 yuan, ROE is 5%. Company A’s efficiency in generating returns with the same capital scale is much higher than Company B.

Market Practice Version (Weighted Average ROE):

ROE = P ÷ ( + NP ÷ 2 + Ei×Mi ÷ M0 - Ej×Mj ÷ M0)

This involves variables like beginning-of-period net assets, net profit during the reporting period, and changes in net assets, ensuring the calculation better reflects actual operational conditions.

Key Advantage: ROE can compensate for the shortcomings of earnings per share (EPS). After stock dividends or bonus issues, EPS may decline, but ROE accurately reflects the company’s true profitability.

The Difference Between ROE, ROA, and ROI

These three metrics are often confused in investment analysis, but each has its own purpose:

ROA (Return on Assets) = Net Income ÷ Total Assets

ROA measures how much net profit a company can generate per unit of assets, assessing management’s ability to profit from all assets. Compared to ROE, which focuses on shareholders’ equity, ROA has a broader perspective, covering all assets.

ROI (Return on Investment) = Annual Profit ÷ Total Investment × 100%

ROI is a tool for evaluating investment projects. Its advantage is simplicity, but it ignores the time value of money, often underestimating long-term projects with extended construction periods. ROI is usually time-specific, based on a particular year.

Relationship: ROE focuses on shareholders’ capital, ROA on total assets, and ROI on specific projects. In corporate analysis, ROE best reflects the efficiency of using shareholders’ funds.

Pitfalls and Truths of Using ROE for Stock Selection

Misconception 1: The higher the ROE, the better

This is the most common mistake. Rearranging the formula: ROE = ( Market Value ÷ Net Assets) ÷ ( Market Value ÷ Net Profit) = PB ÷ PE

To make ROE soar to extremely high levels, under relatively stable PE, it often requires a significant increase in PB (Price-to-Book ratio), which may indicate a stock valuation bubble forming. Investing in such stocks carries higher risk.

Misconception 2: Ignoring the sustainability of ROE

Historical data shows that maintaining a 15% ROE over the long term is rare. For example, a stock trading at 10x PE and 2x PB can have an ROE of up to 20%; at 10x PE and 5x PB, ROE can reach 50%. Such figures are hard to sustain—high ROE attracts competitors, weakening the company’s moat; also, growth from 2% to 4% is easy, but from 20% to 40% is exponentially more difficult.

Correct Stock Selection Standard:

Focus on companies with an ROE in the 15%-25% range, and track their trend over the past five years. While past data cannot predict the future, it reflects whether the company’s profitability is continuously improving. A consistent upward trend is better than a high plateau; this indicates a truly high-quality company.

How to Check a Stock’s ROE

To quickly find out a stock’s ROE, you can use free platforms like Google Finance, Yahoo Finance, or major brokerage websites. For screening stocks by market ROE, visit professional stock screening websites for data retrieval and ranking.

ROE Rankings in Different Markets for 2023

Taiwan Stock Market Top 20 ROE

Note: ROE is based on the latest fiscal year data; market cap as of August 2023.

US Stock Market Top ROE Samples

Hong Kong Stock Market ROE Examples

Note: ROE is based on the latest fiscal year data; market cap as of August 2023.

Building an Investment Decision Framework

ROE is an important tool for analyzing corporate value but is not万能. When using ROE for stock selection, follow these principles:

First, set a reasonable ROE range (15%-25%) rather than blindly chasing high values; second, analyze the company’s ROE trend over the past five years—continuous improvement is a good sign; third, combine ROE with valuation metrics like PE and PB for multi-dimensional validation of investment value.

Finally, remember the essence of investing—independent thinking, adherence to strategy, and maintaining the right mindset are the keys to long-term profits.