Is Return On Equity A Company’s Financial Barometer?

Significance of ROE

Comparing a company’s return on equity (ROE) to its industry average or the ROE of similar companies can help investors determine whether the company is performing well or underperforming. Bhavya Rathod highlights how this can be used as an effective tool in the investment process 

“Return on equity is a huge determinant of corporate value.” This famous quote by legendary investor Warren Buffet rightfully indicates that return on equity (ROE) is a powerful financial ratio that helps investors gauge the profitability and efficiency of a company. It measures profitability by comparing a company’s net income to its shareholders’ equity. ROE is a critical metric for investors because it helps them evaluate how well a company is generating profits from the money that shareholders have invested in the business.
 

Significance of ROE

Joel Greenblatt, a hedge fund manager and author of ‘The Little Book That Beats the Market’, developed a formula for ranking stocks based on their ROE and earnings yield. Greenblatt believed that companies with high ROE and low valuations could outperform the market over time. High ROE is generally an indication of a profitable company that is efficiently utilising its resources, whereas low ROE may suggest that a company is not effectively utilising its shareholders’ equity to generate profits.