The Most Important Number in Business
Return on equity (ROE) measures the profit a business generates relative to the equity capital it employs. It is calculated as net income divided by shareholders' equity, expressed as a percentage. A business earning £10 million on £100 million of equity has a 10% ROE.
For investors, ROE is a fundamental measure of management's skill in deploying capital. A high and sustained ROE indicates that a business can reliably earn more than a normal return — typically a sign of competitive advantage. A declining ROE may indicate erosion of that advantage, rising competition, or poor capital allocation decisions.
Warren Buffett has repeatedly stated that he looks for businesses earning consistently high returns on equity without requiring excessive leverage. His long-term test for a great business is a sustained ROE of 15% or more, achieved through genuine competitive advantage rather than financial engineering.
The DuPont Decomposition
Simply observing ROE is useful, but decomposing it reveals where the return is actually coming from. The DuPont analysis breaks ROE into three components:
ROE = Net Profit Margin × Asset Turnover × Equity Multiplier
- Net profit margin (net income / revenue) captures how efficiently the company converts sales into profit
- Asset turnover (revenue / total assets) captures how productively assets are deployed
- Equity multiplier (total assets / shareholders' equity) captures how much leverage is being used
Two companies with identical ROEs may be achieving it very differently. A luxury goods company might have a high margin and low asset turnover. A supermarket might have a razor-thin margin but very high asset turnover. A financial institution might primarily lever up its equity. Understanding which driver underlies ROE helps assess its sustainability.
Return on Invested Capital
Return on invested capital (ROIC) is a more comprehensive measure than ROE because it includes all capital employed — both equity and debt — in the denominator. It is calculated as net operating profit after tax (NOPAT) divided by invested capital (equity plus net debt). Unlike ROE, ROIC is not affected by the company's choice of capital structure, making it more useful for comparing companies with different levels of leverage.
The critical benchmark for ROIC is the weighted average cost of capital (WACC) — the blended required return of equity and debt holders. A company where ROIC exceeds WACC is creating value: each reinvested pound generates more than it costs. A company where ROIC falls below WACC is destroying value even if it is profitable and growing. Michael Mauboussin has documented extensively that the ability to sustain a high ROIC spread is the defining financial characteristic of excellent businesses.
Capital Allocation: What Management Does with Earnings
A profitable business generates more cash than it needs to operate. What management does with that surplus — how they allocate capital — is one of the most consequential determinants of long-run shareholder value.
Capital allocation options include: reinvesting in the core business (organic growth); acquiring other businesses (M&A); returning cash to shareholders via dividends; and buying back shares (repurchases). Each has different risk and return implications.
William Thorndike, in his 2012 book The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, documented eight CEOs who dramatically outperformed the market over multi-decade periods. His central finding was that superior capital allocation — not operational excellence or charisma — was the primary driver of their results. The best capital allocators treated the deployment of the company's cash as a rational exercise in return on investment, irrespective of prevailing fashion or short-term market pressure.