Net income divided by shareholders equity; the accounting return earned on the capital owners have left in the business.
ROE is the headline return measure, but it is easily flattered. Debt raises it, buybacks shrink the denominator, and write-offs shrink it further, so a company can report a high ROE precisely because its balance sheet has been damaged.
dupont-analysis decomposes it into net-margin, asset turnover and leverage, which shows immediately whether the return comes from operations or from borrowing.
Example: Northwind Tools earns $78M on $570M of average equity, a 13.7% ROE. Excluding the $240M of goodwill, return on tangible equity is 35%, which is the acquisition accounting talking.
Original diagrams for the ideas on this page. Illustrative, not real market data.
Margin and leverage. A $5,000 deposit can control a $100,000 position, which is 20:1 leverage. Because the loss is measured on the full $100,000, a 2.5% move against you halves the deposit and brings a margin call, and a 5% move uses all of it.
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