10 How to Interpret Return on Equity (ROE): Focus on Three Factors

Return on Equity (ROE) is a key profitability metric that investors often use to evaluate companies. Calculated by dividing net income by a company's equity, ROE is also known as Return on Shareholders' Equity. Charlie Munger believed that companies with higher ROE levels tend to provide higher long-term returns for their stock investors.

By breaking down ROE, we can see that：

Net margin reflects a company's competitiveness in its products or services. Companies with high net margins may have fewer competitors or deeper moats like brand recognition or advanced technology.

Asset turnover ratio reflects a company's operational efficiency. Higher asset turnover ratios may indicate higher levels of management capabilities.

Equity multiplier represents a company's leverage level. By increasing debt or reducing shareholder equity, companies can amplify operating leverage to increase potential profits, but financial risk may also increase.

Companies with higher financial leverage may be more susceptible to economic downturns. Some companies with higher net profit margins may have strong brand or technological advantages, leading to increased profits. They may reinvest their profits into the business, thereby increasing the ability to create more profits.

Therefore, higher ROE resulting from higher net margins may be more sustainable and worth evaluation.