Buffett's most valued stock selection indicator: ROE formula and the 15%-25% golden rule

Want to know how Warren Buffett, the stock market wizard, selects good companies? The answer is simple—he looks at just one indicator: Return on Equity (ROE). Buffett has explicitly stated that companies with ROE consistently above 20% over the years are high-quality companies worth buying. But there’s a trap here: is higher ROE always better? Not quite.

What exactly is ROE, and why is it so important?

Return on Equity (ROE) is a core metric that measures a company’s ability to generate profit from its own capital. Simply put, it shows how much profit a company makes for each dollar of shareholders’ equity invested.

ROE formula is straightforward: ROE = Net Profit ÷ Shareholders’ Equity

This indicator is important because it reflects how efficiently management uses capital. Compared to metrics like earnings per share, ROE provides a more truthful picture of a company’s profitability—even if the company issues new shares or distributes dividends, causing EPS to decline, a stable or rising ROE indicates the company’s actual earning power remains intact.

How is ROE calculated in the stock market?

A simplified version is: Net Profit ÷ Shareholders’ Equity. But in the stock market, the calculation is much more complex because it considers changes in net assets over reporting periods:

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

Where:

• P = profit for the reporting period
• E0 = beginning of period net assets
• Ei = increase in net assets (new share issuance, debt-to-equity swaps, etc.)
• Ej = decrease in net assets (buybacks, dividends, etc.)
• Mi, Mj, M0 = corresponding months

Simple example: Company A has net assets of 1,000 units and after-tax profit of 200 units this year, so ROE is 20%; Company B has net assets of 10,000 units and profit of 500 units, so ROE is only 5%. Clearly, Company A uses capital more efficiently.

What’s the difference between ROE, ROA, and ROI?

Understanding these three metrics helps avoid analysis confusion:

ROE (Return on Equity) = Net Profit ÷ Shareholders’ Equity, measures the efficiency of using shareholders’ funds.

ROA (Return on Assets) = Net Profit ÷ Total Assets, measures the ability to generate profit from all assets (including borrowed funds).

ROI (Return on Investment) = Annual Profit ÷ Total Investment × 100%, measures the return of a specific investment project.

Each has its focus: ROE on shareholders’ equity, ROA on total assets, ROI on individual projects.

The truth about ROE-based stock selection: higher isn’t always better

This is the easiest trap to fall into. Many investors get excited when a stock’s ROE hits 100%, but in reality, this is often a trap.

Let’s look at the math. Since ROE = Net Profit ÷ Shareholders’ Equity, it can be rearranged as:

ROE = PB ÷ PE

Where PB is the Price-to-Book ratio, and PE is the Price-to-Earnings ratio. If PE remains stable, a high ROE can only be achieved if PB skyrockets. But if PB becomes excessively high, it indicates a bubble.

For example: If a stock has a PE of only 10 (cheap), but PB is 5 (expensive), then ROE appears to be 50%. However, such “high ROE” is hard to sustain. Historically, stocks with ROE above 15% over the long term are rare, and companies with ROE reaching 50% are generally unsustainable.

Moreover, abnormally high ROE attracts massive capital inflows, intensifying industry competition. Companies lacking strong core competitiveness are easily beaten by new entrants. More importantly, once ROE reaches extremely high levels, the room for future growth diminishes—it’s easy to go from 2% to 4%, but from 20% to 40% is extremely difficult.

Practical standards for ROE stock selection

Investors should follow these principles when evaluating ROE:

First, the ROE range should be reasonable. Aim for a range of 15%-25%. This indicates good profitability and relatively rational valuation without obvious bubbles.

Second, look at long-term trends. Don’t focus on single-year data; review at least 5 years of ROE performance. If ROE is stable or steadily rising, it shows the company’s earning power is improving; if volatile, be cautious.

Third, combine with other indicators. Relying solely on ROE isn’t enough; consider PE, PB, cash flow, debt ratio, and other factors for a comprehensive assessment.

ROE rankings in different markets in 2023 (as of August)

Here are some representative companies with outstanding ROE performance:

Taiwan Stock Market TOP 5:

Hong Kong Stock Market TOP 5:

US Stock Market TOP 5:

Note: Some ROE figures are extremely high, often corresponding to companies with very small market caps. Such extreme cases should be approached with caution.

How to check a stock’s ROE?

You can find ROE data on Google Finance, Yahoo Finance, or your local brokerage websites. To quickly filter stocks with the highest ROE, use professional stock screening tools to set criteria and sort accordingly.

Investment insights

ROE is an important tool for analyzing company value, but it is not an absolute truth. The key to successful investing is: independent thinking, following a stable stock selection logic, and maintaining a rational mindset.

Remember Buffett’s advice: companies with stable ROE between 15%-25% and a long-term upward trend are worth paying attention to. But also beware of traps where ROE appears artificially high. Combine valuation metrics like PE and PB for a comprehensive judgment to make truly scientific and rational investment decisions.