Picture this: If you were going to buy a company—essentially buying a business—what would you care about most? I’m guessing it’s "money-making efficiency," right? The whole point of buying a company is to make money, so you want to know exactly how much you're getting back for every dollar you put in.
There’s a metric in the financial statements called Return on Equity (ROE) that measures exactly that efficiency. Let's think like Warren Buffett and use ROE to spot the kind of great companies that are worth holding for the long haul.
Why is Warren Buffett so big on ROE? Because it shows a company's money-making efficiency.
ROE = Net Income / Shareholder Equity x 100%
You hear Return on Equity (ROE) thrown around all the time. It's the core metric for measuring efficiency. The concept is simple: "How much profit did the company bring in using the shareholders' money?"
In this formula, "Shareholder Equity" is basically the company's "Net Worth." It’s what’s left after you subtract all the liabilities from the total assets—the capital that truly belongs to the shareholders. And like we mentioned in the Income Statement section, "Net Income" is the real profit left over after paying taxes. So, the ROE formula tells you the return on that capital (usually calculated quarterly or yearly). The higher the number, the better the efficiency. It shows you exactly how much profit is generated for every single dollar invested.
This is exactly why Warren Buffett places so much weight on this metric. A company that maintains a high ROE over the long term has a powerful profit engine. It doesn't need to keep asking shareholders for more money (like issuing new stock); it can keep growing just by using the profits it earns. This is the key to generating incredible compound interest. It's the definition of a great business that can roll its own snowball.
Why use ROE and ROA together? Looking at profit from every angle
We know ROE is like a powerful profit engine. But if you drive watching only the speedometer while ignoring the gas gauge, you're asking for trouble. Relying on ROE alone can sometimes make us miss the "quality" of those profits and the potential risks lurking underneath.
The ROE Trap: Is it Real Strength or Just a Mirage Built on Debt?
That formula we just talked about, ROE = Net Income / Shareholder Equity, looks solid at first glance. But looking at it in isolation creates a blind spot.
Let's say a company borrows a massive amount of money from the bank to buy land and build factories for a huge expansion. Regardless of efficiency, their revenue and profit numbers will almost certainly go up. But since Shareholder Equity doesn't change, the ROE shoots up. Or maybe they pump up inventory to boost sales. It's the same thing. Profit rises, equity stays the same, and ROE looks amazing.
It's like a sprinter on steroids. Their times are incredible, but we all know it's not their true strength. It carries a huge hidden risk. Once the situation flips, like interest rates rising and making those loan payments unbearable, that athlete could collapse in an instant.
Where ROA Comes In: Checking the Company’s Health from a Broader Angle
ROA = Net Income / Average Total Assets × 100%
We just looked at ROE, which measures the efficiency of "Net Assets." ROA takes a different angle and looks at the efficiency of "Total Assets."
Total Assets includes debt. It counts both the company's own capital and all the money it borrowed. So if a company tries to boost its revenue numbers by using leverage or piling up inventory, it can't hide from ROA.
- High ROE, Low ROA: This company's profit is likely being propped up mostly by borrowing money.
- High ROE, High ROA: This is the real deal! They are creating amazing returns for shareholders just by running their core business well.
Spotting the profit moat by watching roe and roa over the long haul
We've already learned how to use ROE and ROA to judge a company's efficiency and the quality of its profits. In Warren Buffett's playbook, seeing consistent and high-quality ROE and ROA numbers over the long term is a big deal. It acts like a protective moat around the business.
Any company can get lucky, ride a hot industry trend, or launch one hit product to put up great numbers for a year or two. But that kind of "flash in the pan" success gets eaten up pretty fast by ruthless competition.
Only truly great companies can fend off those attacks. If a company can keep its money-making efficiency high for a long time, it definitely has some kind of moat. It could be brand value like Coca-Cola, a low-cost structure like Costco, high switching costs like the Apple ecosystem, or network effects like Facebook.
We want to pick profitable and healthy companies
Now that we have gone over ROE and ROA, I hope you have a different angle on how to evaluate a company.
Let's keep one thing in mind. A good business doesn't just need to be great at making money for shareholders (High ROE). It also needs to earn that money smartly and healthily (Solid ROA). And behind all of that, there is bound to be a strong moat silently guarding it.
