Investor Must-Read: The Stock Selection Logic Behind the ROE Formula and Its Practical Application

Understanding Corporate Profitability from the ROE Formula

ROE (Return on Equity) is a core financial metric used to evaluate a listed company’s profitability efficiency, reflecting how well the enterprise utilizes shareholder capital to generate earnings. In simple terms, ROE formula: Return on Equity = Net Profit ÷ Shareholders’ Equity.

This seemingly straightforward formula actually reveals an important logic: how much shareholder capital is needed for a company to earn 1 yuan of profit. The higher the ROE, the less equity capital is required to generate more profit, indicating stronger capital operation efficiency.

In practical stock market applications, the calculation of ROE can be more complex. Listed companies often use a weighted average ROE, incorporating changes in net assets during the reporting period to ensure data accuracy and comparability. In contrast, the ROE formula for general enterprises is more direct: after-tax profit divided by owner’s equity, which yields the net asset return for that year.

The Substantive Differences Between ROE, ROA, and ROI

Three commonly used but distinct indicators in investment analysis are:

ROE (Return on Equity) focuses on the return on shareholders’ invested capital, measuring management’s efficiency in using shareholders’ funds.

ROA (Return on Assets) examines the profitability of all assets (including debt-financed assets), calculated as: ROA = Net Income ÷ Total Assets. ROA provides a more comprehensive reflection of asset allocation rationality.

ROI (Return on Investment) is calculated as: Annual Profit ÷ Total Investment × 100%, mainly used to evaluate the returns of individual investment projects. Its advantage is straightforward calculation, but it neglects the time value of money and has weaker timeliness.

The core difference lies in: ROE focuses on equity, ROA on total assets, and ROI on specific investment projects.

The Pitfalls of ROE Stock Selection: Why “Higher is Better” Is a Misconception

Warren Buffett once said that if he had to choose just one indicator for stock selection, he would choose ROE, emphasizing that companies maintaining an ROE above 20% for many years are worth investing in. This statement is regarded as a golden rule by many investors, but it overlooks a key premise: ROE must be stable and sustainable.

Rearranging the ROE formula yields: ROE = PB ÷ PE (where PB is the Price-to-Book ratio, PE is the Price-to-Earnings ratio). This form reveals a market reality:

If PE remains stable within a reasonable range over the long term, then to see ROE soar to 50% or higher, PB must also increase significantly. An excessively high PB often indicates a market bubble in the company’s valuation.

For example, a stock with a PE of 10 and a PB of 5 would have an ROE of 50%. While this high ROE seems attractive, it is difficult to sustain. Historical data shows that stocks with ROE above 15% are rare, and reaching 30% or more is almost impossible.

Excessively high ROE also attracts continuous capital inflows into the industry, intensifying competition. Companies with core competitiveness may be eroded by new entrants. Once ROE peaks, future growth potential becomes severely limited.

Practical ROE Stock Selection Criteria

Considering sustainability and growth potential, a reasonable ROE range for stock selection should be between 15% and 25%. More importantly, investors should examine the trend of ROE over at least the past 5 years, rather than single-year figures.

If a company’s ROE rises from 2% to 4%, it is relatively easy; but increasing from 20% to 40% is extremely difficult. The former indicates early growth stage, with industry competition still forming; the latter suggests a mature phase with resource allocation near its limit.

Ideal stock candidates should meet the following conditions:

• ROE maintained between 15% and 25%
• ROE shows a stable or mildly increasing trend over the past 5 years
• No drastic fluctuations in ROE curve

Such companies are usually industry leaders or near-leaders, with sustainable profitability.

How to Check Individual Stock ROE Data

The most convenient channels for checking ROE include international financial platforms like Google Finance, Yahoo Finance, or major local securities firms’ websites. To quickly screen for stocks with high ROE rankings, visit specialized websites for retrieval and sorting.

2023 Major Market ROE Performance

Taiwan Stock Market Top 20 ROE

US Stock Market Top 10 ROE

Hong Kong Stock Market Top 10 ROE

Data updated to August 2023

Final Investment Decision Advice

ROE, as an important indicator of corporate profitability efficiency, is invaluable. However, the market does not follow the simple logic of “the higher the ROE, the better.” Instead, it requires balancing sustainability, growth potential, and market valuation.

Using ROE in conjunction with valuation metrics like PE and PB, observing long-term trends over 5 years or more rather than single data points, and analyzing industry prospects and competitive landscape, constitute a prudent stock selection approach. Remember: independent thinking, adherence to strategy, and maintaining a calm mindset are the three key elements of successful investing.