Return on equity and return on capital

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Key idea: A business that earns a high return on the money invested in it can grow without needing much new cash. That is one of the clearest signs of quality.

Return on equity (ROE) is yearly profit divided by shareholders' equity. If owners have $1 billion in the business and it earns $150 million, ROE is 15%.

ROE can be pumped up with debt: borrow heavily, shrink equity, and the same profit looks like a bigger return. Return on invested capital (ROIC) avoids that trick by measuring profit against all the money in the business, from lenders and owners together.

Why it matters: a company earning 20% on capital can reinvest its profits and compound quickly. One earning 5%, below its cost of capital from Day 9, destroys value every time it expands, even if sales grow.

High returns that last for many years usually point to something competitors find hard to copy: a brand, a network, low costs or high switching costs. That is often called a moat.

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Profit is $60 million and shareholders' equity is $400 million. What is ROE?

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