Is a higher ROE selection really better? The 3 most common misconceptions among investors

Many people hear that Buffett advocates ROE-based stock selection and dive straight into finding stocks with the highest ROE. But there’s a trap here—ROE is not necessarily better the higher it is. In fact, those with abnormally high ROE often hide bubble risks.

What Does ROE Actually Measure?

Return on Equity (ROE) essentially equals Net Profit ÷ Shareholders’ Equity, used to see how much a company earns with its own capital. If a company has net assets of 1,000 yuan and earns 200 yuan profit, the ROE is 20%. In theory, the higher this number, the more efficient the operation.

But the problem is, many investors only look at surface numbers without understanding the mathematical structure of ROE. Using a transformed formula makes it clear: ROE = PB ÷ PE (where PB is the Price-to-Book ratio, PE is the Price-to-Earnings ratio).

This means that if PE remains unchanged, an increase in ROE can only come from an increase in PB—that is, the stock price relative to net assets is rising. When PB exceeds 5 or even 10 times, that high ROE actually reflects valuation bubbles, not operational capability.

3 Major Traps Hidden in High ROE

Trap 1: Unsustainable False Prosperity

A stock with a PE of only 10 and a PB of 5 can have an ROE of 50%. But such extreme combinations are hard to sustain long-term historically. Going from 2% to 4% ROE is relatively easy, but jumping from 20% to 40% is much harder—because high ROE attracts competitors, and increased competition will inevitably squeeze profit margins.

Trap 2: Bubble Risk

Excessively high ROE often indicates that market expectations for the company are already overextended. Once expectations fall short, the stock price can adjust significantly. Moreover, companies lacking core competitiveness are easily eroded by new entrants, causing previously high ROE to collapse instantly.

Trap 3: Limited Growth Potential

ROE already at a historical high suggests limited room for future improvement. Investment returns come from both fundamental improvement and valuation expansion. If ROE is already at a ceiling, relying solely on valuation expansion is risky.

How to Use ROE Correctly for Stock Selection

Step 1: Set a Reasonable ROE Range

Not the higher the better, but 15%-25% ROE is safest. This range reflects good operational efficiency, leaves room for growth, and maintains relatively rational valuation.

Step 2: Look at 5-Year Data

Single-year ROE is meaningless. Focus on the trend over the past five years—a consistently stable rising ROE is a good signal, indicating the company’s earning ability is steadily improving, not just a flash in the pan.

Step 3: Compare PB and PE

Don’t just focus on ROE; also check whether the company’s PB and PE are reasonable. High ROE combined with low PE and moderate PB presents real opportunities. Conversely, if PE is already very high and ROE is still high, it’s a bubble.

How to Distinguish ROE from ROA and ROI

Three common but easily confused metrics in investment analysis:

• ROE (Return on Equity) = Net Profit ÷ Shareholders’ Equity, measures the return on shareholders’ invested capital.
• ROA (Return on Assets) = Net Profit ÷ Total Assets, measures the efficiency of using all assets, including borrowed funds.
• ROI (Return on Investment) = Annual Profit ÷ Total Investment × 100%, a broad measure of investment return but often ignores time costs and risks.

In simple terms: ROE reflects shareholder returns, ROA shows overall asset utilization efficiency, ROI is a rough estimate of investment return.

Overview of High-ROE Stocks in Different Markets in 2023

Taiwan Stock Market TOP 5 ROE

US Stock Market TOP 5 ROE

Hong Kong Stock Market TOP 5 ROE

Note: Data as of August 2023. These extremely high ROEs warrant caution—they may be due to small market caps causing volatility or companies in transition.

Final Investment Advice

ROE is indeed a key indicator of company quality, but only if used correctly. Don’t be fooled by a single number—look at long-term trends, reasonable ranges, and valuation alignment. The ideal stock picks are those with: ROE stable between 15%-25%, rising over the past five years, and PE/PB at industry-average levels.

Combine with other fundamental indicators, stick to your investment strategy, and that’s the true path to successful investing.