Investment Must-Read: ROE Stock Selection Guide and Financial Indicator Applications

Why Should You Pay Attention to ROE?

If you want to find truly profitable good companies, there is one indicator you must master—Return on Equity, commonly known as ROE. Warren Buffett once said that if he could only use one indicator to select stocks, he would choose ROE without hesitation. Companies that can consistently maintain an ROE above 20% year after year are often worth investors’ attention. However, the problem is that many people’s understanding of ROE remains superficial, and some even believe that the higher the ROE, the better. In reality, this perception is a significant misconception.

What Exactly Is ROE?

Return on Equity (ROE) is the core meaning of: dividing a company’s after-tax profit by its net assets, resulting in a percentage. In other words, this indicator reflects how much profit is generated per yuan of shareholders’ equity.

The formula is simple: ROE = Net Profit ÷ Net Assets

Net profit includes after-tax profit and profit distribution, while net assets include owner’s equity plus minority shareholders’ equity. Under normal circumstances, it can be simplified as: after-tax profit divided by owner’s equity.

For example, Company A has net assets of 1,000 yuan and an after-tax profit of 200 yuan this year, so its ROE is 20%; Company B has net assets of 10,000 yuan and an after-tax profit of 500 yuan, so its ROE is only 5%. Compared to that, Company A’s capital efficiency is obviously higher.

Weighted ROE Calculation in the Stock Market

Real stock market calculations are more complex. Listed companies use a weighted average ROE that considers changes in net assets during the reporting period. The formula is:

ROE = P ÷ (E0 + NP ÷ 2 + Ei × Mi ÷ M0 - Ej × Mj ÷ M0)

Where P represents profit for the reporting period, E0 is net assets at the beginning of the period, Ei and Ej represent increases and decreases in net assets, and M0, Mi, Mj are the corresponding months. This formula provides a more accurate reflection of a company’s profitability efficiency over the entire reporting period.

What Are the Differences Between ROE, ROA, and ROI?

Investors often confuse these three similar indicators and must understand their fundamental differences.

ROA (Return on Assets) measures how much net profit is generated per unit of total assets. The calculation is net income divided by total assets. This indicator focuses more on management’s efficiency in utilizing all assets, including both owned and borrowed funds.

ROE (Return on Equity) only considers the return generated from shareholders’ own invested capital, excluding borrowed funds.

ROI (Return on Investment) is a broader concept applicable to any investment activity. It is calculated as annual profit divided by total investment. The advantage of ROI is its simplicity, but it does not account for the time value of money, which may lead to an overestimation of investment value.

In simple terms, ROA looks at the efficiency of all assets, ROE at the efficiency of equity capital, and ROI at the return on investment. They have different perspectives and are suitable for different scenarios.

The Hidden Relationship Between ROE and PE, PB Ratios

Here is an interesting mathematical transformation: ROE = Net Profit ÷ Net Assets = (Market Value ÷ Net Assets) ÷ (Market Value ÷ Net Profit) = PB ÷ PE

In other words, ROE is actually the result of PB (Price-to-Book ratio) divided by PE (Price-to-Earnings ratio). This relationship reveals an important truth.

PE ratios are generally considered reasonable within the 20-30 times range. To make ROE soar, the only way is to significantly increase PB. But when PB is too high, it indicates that the stock of this company is in a bubble. A stock with a low PE and high PB combination indeed corresponds to an abnormally high ROE, but such high ROE is often unsustainable.

Historical data shows that stocks maintaining a long-term ROE of 15% are rare. For example, a PE of 10 times with a PB of 2 times yields an ROE of 20%; with a PE of 10 times and a PB of 5 times, ROE jumps to 50%—these levels are impossible to sustain long-term.

Excessively High ROE Can Be a Hidden Risk

When ROE is abnormally high, it attracts a large influx of capital into that industry, intensifying competition. Companies lacking core competitiveness are easily replaced by new entrants. Additionally, extremely high ROE indicates limited room for future growth—raising ROE from 2% to 4% is relatively easy, but from 20% to 40% is extremely difficult because the industry environment is entirely different.

Therefore, investors should focus on long-term performance when observing ROE, rather than short-term peaks. The ideal scenario is ROE maintained between 15%-25% with a steady upward trend. Paying attention to data from the past five years is important; although history cannot predict the future, it can reflect whether a company’s profitability is steadily improving.

How to Use ROE for Stock Selection?

The core principle of ROE-based stock selection is moderation. It’s not about chasing the highest ROE, but about finding companies with stable and growth potential. A recommended range is 15%-25%, and it’s essential to track the trend over the past five years.

If a company’s ROE can be maintained within this range year after year and shows a gradual upward trend, it indicates the company is improving its profitability efficiency. Conversely, if ROE fluctuates significantly or suddenly surges, caution is advised.

Combine ROE with other indicators such as PE, debt ratio, and cash flow for a more accurate assessment of investment value. Independent thinking, sticking to your investment logic, and maintaining a stable mindset are the keys to successful investing.

ROE Query Tools and Resources

To check the ROE of a particular stock, you can use free platforms like Google Finance, Yahoo Finance, or log into local brokerage websites.

If you want to screen for stocks with the highest ROE, visit professional stock screening websites and sort by market category and ROE. Most sites offer screening functions for US stocks, Hong Kong stocks, Taiwan stocks, and other markets, allowing investors to set their own filtering criteria.

High ROE Stocks in Various Markets in 2023 (Reference)

Taiwan High ROE Stocks (August 2023)

US High ROE Stocks (August 2023)

Hong Kong High ROE Stocks (August 2023)

Data is based on the latest fiscal year, with market cap figures as of August 8, 2023.

Summary

ROE is one of the most important indicators in financial analysis and has high reference value for investment decisions. However, the key is to understand its essence and avoid blindly pursuing high figures. The best ROE-based stock selection criteria are companies with moderate to high, stable, and gradually increasing ROE over the long term. When combined with other financial indicators, this approach can help make smarter investment choices.