From theory to practice: How to calculate ROE and apply it to your investment strategy

When you decide to enter the world of investments, one of the first questions that arises is: how do I know if I am truly making money efficiently? The answer is not always in absolute numbers, but in how those numbers relate to each other. This is where return on equity (ROE) becomes your best ally.

Beyond the name: understanding what ROE really is

Before learning how to calculate ROE, you need to understand its true meaning. This indicator shows you precisely how much profit a company generates for each unit of capital that its shareholders have invested. In other words, it measures the efficiency with which an organization converts its owners’ money into real earnings.

Imagine you own a store. ROE would tell you: “Of all the money you invested, how much am I really earning?” A high ROE indicates that your business is an efficient profit generator. A low ROE suggests there is room for improvement, or that capital is being underutilized.

This parameter is fundamental because it combines two critical pieces of information: the company’s net income (what it earns after all expenses) and the shareholders’ equity (what truly belongs to them after paying debts). Together, they offer a clear perspective on financial health and value creation capacity of any investment.

The practical method: formula and steps to calculate ROE

The beauty of ROE lies in its simplicity. To know how to calculate ROE, you only need two numbers from a company’s financial statement:

Step 1: Obtain the annual net income (available in the income statement)

Step 2: Obtain the total shareholders’ equity (available in the balance sheet)

Step 3: Divide net income by shareholders’ equity

Step 4: Multiply the result by 100 to get the percentage

The basic formula is: (Net Income / Shareholders’ Equity) × 100 = ROE %

Let’s take a concrete example. META reported in Q3 2022 a net profit of approximately $18.5 billion, with shareholders’ equity of $124 billion. Applying the formula:

$18.5 billion / $124 billion = 0.149 × 100 = 14.9% ROE

This means that for every dollar of shareholders’ capital, META generated approximately 14.9 cents of profit. A result that needs context to be properly evaluated.

Contextual interpretation: sector comparison and benchmarks

An ROE of 14.9% may sound good in isolation, but is it really? This is where you make the first common mistake in investment analysis.

Suppose you are deciding between two software companies. Company A (entertainment software, similar to Microsoft) showed an ROE of 42.1% in Q3 2022. Company B (internet software, similar to META) had the 14.9% mentioned. At first glance, Company A seems clearly superior. However, sector context is crucial.

The entertainment and consumer software sector typically generates higher margins than the internet software sector. Company B’s ROE could be well above its industry average, while Company A’s might be just average or even slightly below.

To evaluate correctly, you need to know the average ROE of your sector. An analysis of the 10 largest companies in the S&P 500 by market capitalization in 2017 showed a weighted average ROE of 18.6%. More recently, as of late November 2022, Alphabet Inc. recorded an ROE of 26.41%, while Amazon barely reached 8.37%. These variations illustrate why direct comparison without context can be misleading.

Hidden traps: when ROE lies

An exceptionally high or abnormally low ROE should trigger your analyst alarm. Several factors can distort this indicator in ways that are not immediately obvious:

Negative earnings or equity: If a company reports both negative income and negative equity, the mathematical result can be misleadingly high. Always verify that both figures are positive before trusting the number.

Earnings volatility: Imagine a company that has accumulated losses over years. Suddenly, an exceptional year with massive profits but artificially depressed equity produces an extraordinary ROE. This is a red flag requiring deep historical investigation.

Excessive leverage: A common but dangerous tactic is that companies increase their ROE simply by taking on more debt. If they borrow at a low rate and invest at a higher rate, ROE mathematically improves without real operational improvement. This is what experts call leverage: it works in good times but becomes a double-edged sword during crises.

Share buybacks: When a company repurchases its own shares, it reduces shareholders’ equity on its books. With a smaller denominator in the formula, ROE artificially rises without actual profitability improving.

Dividends to preferred shareholders: These are deducted from retained earnings, reducing equity and artificially boosting ROE.

One-off events: Extraordinary inventory depreciations or non-recurring events can distort both net income and equity in a specific year, generating a misleading ROE.

Trends versus absolute numbers: the real story

Professor JP Tremblay from the University of Denver points out something critical: “While a company’s absolute ROE is important, the change in ROE over time, and what drove that change, can be even more relevant.” A stable or increasing ROE over 5-10 years is a much more reliable signal than an isolated peak. This metric also helps estimate sustainable growth rates, indicating how fast a company can expand without excessive debt.

Profitability in cryptocurrency markets: adapting the concept

Fundamental analysis that works for stocks also applies to cryptocurrencies, albeit with important nuances. While stocks represent ownership in companies with income, dividends, and equity, assets like Bitcoin and Ethereum operate under completely different dynamics.

To calculate ROI (return on investment, different but complementary to ROE) in cryptocurrencies, the process is more straightforward: take the sale price of the asset, subtract the purchase price, and divide the result by your initial investment, multiplying by 100.

If you bought Bitcoin at $5,000 and sold it at $20,000, your ROI would be ($20,000 - $5,000) / $5,000 × 100 = 300%. You tripled your investment.

However, ROI in crypto is deceptively simple. It does not account for transaction fees, trading commissions, taxes, or opportunity costs of time. A 300% ROI in one month vastly outperforms a 100% ROI over 5 years, but temporal analysis is crucial—do it yourself.

Complementary metrics for more informed decisions

ROE and ROI should never be used as standalone metrics. Complementing them with other indicators provides a more complete view. ROA (return on assets) and other profitability ratios offer additional perspectives on how a company utilizes different aspects of its balance sheet.

In the context of cryptocurrency trading, understanding the asset’s historical behavior, its progression over previous years, market cycles, and macroeconomic factors is as important as calculating ROI.

Practical application: portfolio optimization and reinvestment decisions

Why spend time calculating ROE and understanding these indicators? Because it allows you to make rational decisions about your portfolio.

First, you know which investments are truly generating the returns you seek. If a crypto position shows a negative ROI or below your expectations, you have objective data to decide whether to sell and reinvest that capital into more promising alternatives.

Second, you understand your available cash flow. Knowing how much real money your portfolio is generating allows you to calculate how much new capital you can invest without overextending. A positive cash flow is a prerequisite for sustainable portfolio growth.

Third, you avoid emotional traps. Instead of clinging to positions because “they might still rebound” or panic selling because they have fallen, you have metrics guiding your decisions.

A positive ROI generally indicates that an asset maintains an upward trend in value. A negative ROI signals that value has eroded. Crypto assets with negative ROI deserve special attention: they could be buying opportunities if you believe in recovery, or positions you should liquidate if your investment thesis has changed.

Conclusion: tools, not certainties

Knowing how to calculate ROE and understanding financial profitability provide powerful tools. But remember that no indicator predicts the future. ROE shows how a company has performed in the past. Sector context, historical trends, management quality, and macroeconomic factors determine whether that performance will continue.

Whether analyzing traditional stocks or cryptocurrencies like Bitcoin, Ethereum, or altcoins, the discipline of calculating real returns, comparing them with relevant benchmarks, and monitoring trends is what separates informed investors from lucky speculators. ROE and ROI are your compasses; you decide where to navigate.