The profit a company generates relative to shareholder equity — a measure of how efficiently management converts equity capital into earnings.
“The only real mistake is the one from which we learn nothing.”
— Philip Fisher
Deeper Explanation
Return on equity (ROE) is calculated as net income divided by shareholders' equity. At its most basic, it answers the question: for every dollar of capital that shareholders have invested in and retained in this business, how much profit does the business generate each year? A consistently high ROE — sustained above 15–20% over many years — is a powerful indicator of competitive advantage. It signals that the business can earn well above its cost of capital without requiring constant new equity infusion. Companies that earn high ROEs tend to be those with pricing power, low capital intensity, or significant switching costs — structural characteristics that prevent competitors from eroding margins. ROE has important limitations that investors must understand. A high ROE can be manufactured through financial leverage: borrowing heavily reduces the equity base, inflating the ratio. A business with 20% ROE and minimal debt is very different from one with 20% ROE and 80% debt-to-equity. Always examine ROE alongside the balance sheet. Second, ROE measures return on existing equity — it says nothing about what returns the business earns on new capital. A business that earns 20% on existing equity but only 8% on incremental reinvestment is not a compounder — it is a cash cow. The most powerful growth businesses earn high returns on both existing and new capital. Fisher used ROE as an initial screen but always looked deeper: was the ROE generated by genuine competitive advantage or by financial engineering? The former compounds wealth. The latter is fragile.
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