Lesson 5 of 8
Reading a return on equity
Return on equity rises when a company borrows and again when it buys back shares. The decomposition shows exactly how much of the figure is which.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Return on equity is net income over shareholders equity, and it rises when a company borrows, as long as the assets earn more than the debt costs, whether or not the operations changed.
- Three businesses with nothing in common can report the same 20 percent return from three completely different combinations of margin, turnover and leverage.
- A large share repurchase takes the same amount out of assets and equity, which is a far larger share of equity, so the ratio can print -100 percent for a company earning a steady profit.
Return on equity is the ratio most easily manufactured: borrow money, buy back stock, and the figure rises while the business does exactly what it did the year before. It is worth manufacturing because it is worth having. The decomposition below separates the real part from the borrowed part.
Three companies, the same 20 percent return on equity
- High volume, thin margin · 2.0% margin × 4.0x turnover × 2.5x leverage20%
- Middling on every term · 5.0% margin × 2.0x turnover × 2.0x leverage20%
- Wide margin, no leverage · 20.0% margin × 1.0x turnover × 1.0x leverage20%
One business, two capital structures
The operations are identical. Borrowing half the balance sheet takes return on equity from 12 percent to 20 percent, and return on assets down from 12 percent to 10 percent, because interest reduced the profit while assets stayed the same. Modigliani and Miller's 1958 paper explains why this is not a free gain. Under their assumptions, borrowing raises the expected return on equity and raises the shareholders' risk by exactly enough to leave the firm's value unchanged. The higher ratio is paid for in risk.
Three terms, three paths to the same number
Return on equity is net margin times asset turnover times financial leverage (assets over equity). Check the highlighted bar above: 5.0 percent times 2.0 times 2.0 is 20.0 percent, the same answer as for a company with revenue of 1,600, net income of 80, assets of 800 and equity of 400: 80 divided by 400 is 20 percent. A screen sorted on return on equity puts businesses with nothing in common next to each other. Computed across five or ten filed years for one company, the same decomposition separates two sources of an improving headline: if the leverage term rose, the improvement came from the balance sheet; if margin or turnover rose, it came from operations.
Buffett's argument in the 1979 shareholder letter is that the real test is a high rate of earnings on equity capital, without undue leverage and without accounting distortion. Those two qualifications carry as much weight as the ratio. The first prices the thin-margin company's 2.5 times gearing as risk before its 20 percent is admired. The second excludes a figure produced by a denominator that write-downs or amortising intangibles have hollowed out.
The case where the ratio stops existing
Profit never moved. The third column describes a company earning 50 a year and reads as a catastrophe, because a positive numerator over a negative denominator produces a negative figure that looks like a loss and is not one. ValueScreener shows a company with negative shareholders equity as not meaningful, with the reason attached, rather than as a figure. Negative equity is common enough to move a whole sector's median: Healthcare's return on equity median was -38.97 percent across 813 companies on 2026-09-07.
Do it on a real 10-K
- Compute the three DuPont terms for the last three to five filed years.
- Note which term moved. That is the source of any change in the headline.
- Open the statement of shareholders' equity and check the repurchase line for those years.
Check yourself
A company borrows to fund half its balance sheet, with operating income unchanged. What happens to its return on equity?
- It falls
- It rises, as long as the business earns more on its assets than the debt costs after tax
- It stays the same
Show the answer
Answer: B.
In the worked example, return on equity moves from 12 to 20 percent from financing alone. If the assets earned less than the debt cost, the same borrowing would lower it.Three companies report the same 20 percent return on equity. What can you conclude about them?
- They have similar businesses
- Very little, until the margin, turnover and leverage terms are checked separately
- They carry similar risk
Show the answer
Answer: B.
The same headline figure can come from three unrelated combinations of margin, turnover and leverage.A company's shareholders equity turns negative after large buybacks, while profit stays flat. What should its return on equity show?
- A very high positive number
- A large negative number, showing a loss
- Not meaningful (n/m), because a positive profit over negative equity is not a real ratio
Show the answer
Answer: C.
A negative denominator inverts the sign of a positive result, so the figure is withheld as not meaningful rather than shown as if it were a real return.Sources
- Berkshire Hathaway shareholder letter, 1979: the primary test of managerial performance.
- Modigliani and Miller, "The Cost of Capital, Corporation Finance and the Theory of Investment", American Economic Review, 1958.
- The return on equity distribution published on the open research pages of ValueScreener, built 2026-09-07.
What this leaves out
- The decomposition assumes one company-wide tax rate and constant interest cost; a real company will not reconcile as exactly as the worked examples.
- Whether the numerator is consolidated net income or net income attributable to the parent is a further choice most sources do not state.
- Banks and real estate investment trusts operate at structural leverage levels, and this reading does not transfer to them.
- Nothing here is advice about any security.