The Basics: What ROE Actually Measures
Return on Equity (ROE) = Net Income / Shareholders’ Equity
Sounds straightforward, right? It tells you how much profit a company generates with the money shareholders have invested. But here’s the kicker: what sounds like a good idea in theory can turn into a hot mess in practice.
Problem 1: ROE Loves Leverage a Little Too Much
Here’s a thought experiment: take two companies with identical operating performance. One is conservatively financed. The other has loaded up on debt like a teenager with a credit card. Which one has the higher ROE?
Answer: the one living dangerously.
Why? Because leverage shrinks equity, the denominator in the ROE formula. Less equity means a higher ROE even if nothing has improved operationally. So, a company can boost its ROE by simply taking on more debt—not by actually running the business better.
And unless you’re into Russian roulette finance, that’s not the kind of “performance” you want to reward.
Problem 2: ROE Ignores a Big Chunk of the Picture
ROE conveniently forgets that companies don’t just run on equity—they use all capital: debt and equity. That’s like judging a race car’s performance only by the horsepower of the engine and ignoring the tires, suspension, and, you know, whether the brakes work.
So if you’re trying to figure out how efficiently a company uses its capital, why focus only on the equity portion? That’s like evaluating a restaurant by only tasting the appetizers.
A better approach is to look at metrics that consider the entire capital employed. Which brings us to…
Problem 3: ROE Doesn’t Measure Economic Value Creation
Here’s where things get really serious. ROE can’t tell you whether a company is creating value—or just treading water.
Let’s say a firm has an ROE of 15%. Sounds good? Not so fast. If its cost of equity is also 15%, then shareholders are getting exactly what they’d expect for the risk they’re taking. No more, no less.
Worse yet, ROE completely ignores the company’s cost of capital as a whole. For that, you need to look at the big guns—Return on Invested Capital (ROIC) or Return on Capital Employed (ROCE)—and compare them to the Weighted Average Cost of Capital (WACC).
If ROIC > WACC, the company is creating value. If ROIC < WACC, it’s destroying it—slowly, painfully, and probably with a smile on its face.
ROE doesn’t care. ROE is just there for the party.
So What Should You Use Instead?
If you want to measure real performance—the kind that drives sustainable shareholder value—ditch ROE and reach for one of these:
1. ROIC (Return on Invested Capital)
Takes into account both equity and debt. Tells you how efficiently the company turns capital into profits. Crucially, you can compare it against WACC to assess value creation.
2. ROCE (Return on Capital Employed)
Very similar to ROIC but often uses pre-tax operating profit and total capital employed. Especially useful for comparing capital-intensive businesses.
3. RONA (Return on Net Assets)
This one’s great for asset-heavy businesses. It excludes non-operating assets and gives you a more precise view of how well operating assets are working for you.
Each of these is a much more honest, comprehensive, and strategic metric than ROE. They won’t fall for the leverage illusion, and they actually care whether the company is doing something worthwhile with your money.
Final Thoughts: Don’t Be Fooled by Pretty Numbers
ROE is like that good-looking résumé with a few too many buzzwords and suspiciously short job tenures. It might impress at first glance, but look deeper and you’ll see the cracks.
As a quality investor, your job is to see beyond the surface, to understand how value is actually created, and to focus on metrics that reflect real economic substance—not accounting smoke and mirrors.
So the next time someone tries to wow you with a sky-high ROE, smile politely—and ask about ROIC.
Your portfolio will thank you.
Quality Thesis 
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