Definition
Return on equity measures how much net profit a company generates for each unit of shareholders' equity, expressed as a percentage. It indicates how efficiently the company uses the capital belonging to its shareholders.
How it works
ROE usually divides the past twelve months' net income by average shareholders' equity. A higher ROE means more profit per unit of equity, and it is driven by three things: profit margin, how efficiently assets generate sales, and financial leverage, meaning assets funded by debt rather than equity.
Because debt-funded assets need less equity, a company can raise its ROE simply by borrowing more or buying back shares while becoming riskier. A very small or negative equity base can make ROE look extreme or meaningless, so compare it with peers, its own history and its debt levels.
Formula / convention
ROE = Net income ÷ Average shareholders' equity × 100%
Illustrative example
Illustration with fictional figures: Company A earns HK$120 million on average shareholders' equity of HK$800 million, so ROE is 120 ÷ 800 = 15%. If debt-funded buybacks cut average equity to HK$600 million while profit stays at HK$120 million (ignoring the extra interest cost), ROE reads 20% with no real improvement in the business.
What to watch for
A high ROE built on heavy borrowing or a shrinking equity base signals more risk, not necessarily better quality. One-off gains can also inflate a single year's ROE.