The ROE Trap: Why Your Favorite Company’s ROE Might Be a Lie

Synopsis: High ROE can mislead investors as leverage, buybacks, low equity, or one-time gains inflate returns; sustainable ROE depends on consistency, cash flows, and prudent debt.

A high return on equity (ROE) is often seen as a hallmark of a strong business, quickly drawing investor attention and influencing valuation decisions. However, ROE in isolation can be misleading. It can be inflated by leverage, accounting structures, or short-term gains that do not reflect underlying business strength. Without understanding how those returns are generated and whether they are sustainable, investors risk mistaking financial optics for genuine quality.

What Is ROE and How It Works?

Return on Equity (ROE) is a financial ratio that measures how efficiently a company uses shareholders capital to generate profits. It indicates how much profit a company earns for every rupee of equity invested by its shareholders and is widely used to assess management effectiveness and business quality.

ROE is calculated by dividing a company’s net profit (after tax) by its average shareholders’ equity for the period. The formula is:

ROE = Net Profit ÷ Equity of the Shareholders

For example, if a company earns Rs. 100 crore in profit and has Rs. 500 crore in equity, its ROE is 20 percent. At face value, this looks impressive, as it suggests the company is generating Rs. 20 for every Rs. 100 invested by shareholders. 

How ROE Can Be Inflated

The Leverage Effect

One of the biggest reasons ROE can be misleading is high debt. Borrowing reduces equity, which mechanically increases ROE even if profits remain unchanged. For example, consider two companies earning Rs. 100 crore. Company A has no debt and Rs. 1,000 crore in equity, resulting in a 10 percent ROE. Company B has Rs. 700 crore of debt and only Rs. 300 crore in equity, resulting in a 33 percent ROE. While Company B looks superior on ROE, it is actually far riskier because higher debt increases interest burden and financial vulnerability during downturns.

Share Buybacks

Companies can also boost ROE through aggressive share buybacks. When shares are repurchased, equity reduces, which increases ROE even if profits stay flat. For example, a company earning Rs. 200 crore with Rs. 1,000 crore equity has a 20 percent ROE. If it buys back shares worth Rs. 400 crore using cash or debt, equity falls to Rs. 600 crore and ROE jumps to 33 percent, despite no improvement in operating performance. Investors focusing only on ROE may mistake financial engineering for genuine business growth.

One-Time Gains

ROE can also be inflated by non-recurring events such as asset sales, tax benefits, or accounting adjustments. For instance, if a company sells land and reports a one-time profit of Rs. 300 crore, its ROE for that year may surge sharply. However, this does not reflect sustainable earnings power. Investors who do not adjust for such extraordinary items may overestimate the company’s long-term profitability.

Low Equity Base

Some companies operate with a very low equity base due to accumulated losses, high leverage, or accounting write-downs. Even modest profits can produce extremely high ROE figures in such cases. For example, a company earning Rs. 50 crore with equity of just Rs. 100 crore shows an ROE of 50 percent. While this looks outstanding, it often indicates a fragile balance sheet rather than operational excellence.

ROE Is Not Universally Comparable

ROE varies widely across industries due to differences in capital intensity and business models. Banks and NBFCs typically report high ROE because they operate with leverage as part of their core business, whereas manufacturing companies usually have lower ROE due to heavy asset requirements. Comparing ROE across unrelated sectors; such as a bank versus a steel company can lead to flawed conclusions.

Sustainable vs Unsustainable ROE

A genuinely strong ROE is one that is consistent over time and backed by stable margins, reasonable debt levels, and strong cash flows. Unsustainable ROE, on the other hand, is driven by leverage, buybacks, or one-off events. For example, a consumer goods company delivering 18–20 percent ROE for a decade with low debt is far more reliable than a cyclical company showing 35 percent ROE in one boom year.

Better Metrics to Use Alongside ROE

ROE should be treated as a starting point, not a final verdict. Return on Assets (ROA) helps assess how efficiently a company uses all its assets, not just equity. Debt-to-Equity and Interest Coverage ratios reveal whether ROE is inflated by excessive borrowing. Free Cash Flow shows whether reported profits actually convert into cash. Profit margins and revenue growth help determine whether ROE is driven by strong operations rather than financial leverage.

ROE is a powerful metric, but it is also a dangerous one when used blindly. High ROE does not automatically mean a good company, just as moderate ROE does not imply a weak one. Smart investors look beyond the headline number and examine debt levels, cash flows, consistency, and business quality. In investing, understanding why ROE is high matters far more than how high it appears on paper.

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