Return on equity (ROE) is a term that measures the ratio of net income to the equity invested by the partners or shareholders of a company. This ratio is calculated by dividing net income by shareholders' equity. Expressed as a percentage, it indicates the profitability of the company and its ability to generate profit with the money invested.

A high ROE indicates a good allocation of financial resources to generate cash. Its little brother, ROCE (return on capital employed) takes into account all sources of financing, including debt. A company uses the capital provided by its partners and borrowed funds to invest and run its business. When this activity yields a profit, it is necessary to determine the efficiency of the investments made. This is the role of ROE, which measures the efficiency of the investments made by taking into account only the funds provided by the partners, thus ignoring the debts.

An ROE of 30% means that 10.000 € brought by the associates or shareholders allow to generate 3.000 € of net profit. The more efficient the company is, the higher its ROE and the more investors it attracts. However, it is advisable to compare the ROE of a company with its historical ROE on the one hand, the ROE of the market on the other hand and finally the average ROE of its sector of activities to have a right appreciation of this indicator.

Moreover, ROE is not a stand-alone indicator; it is always necessary to take into account debt management to ensure that the company is on a solid financial footing, in order to reduce the possible risks associated with this investment. Indeed, ROE alone does not take into account the risks taken by the company. A company may have recourse to debt, which increases the ROE by producing a leverage effect, which consequently increases the profitability in an artificial way. This is why an analysis of the balance sheet must be done in parallel.

Stock market history has shown that companies with the best ROE outperform their respective markets. According to a Credit Suisse study, between 1965 and 2015, the top 20% of companies in terms of return on equity (ROE) outperformed the bottom 20% by an average of 17% per year. A study by Greenwald, Kahn, Sonkin, and van Biema (2010) found that ROE is a key driver of long-term stock performance. The study analyzed data on U.S. stocks between 1975 and 2009 and found that companies with high and stable ROE and stable tend to outperform the market over the long term, while companies with low and volatile ROE tend to underperform. Studies of most of the world's stock markets have found the same thing: Hsu, Wu, and Yeh (2014) about the Taiwanese market, Kocenda and Vojtek (2017) about the European market, Haugen and Baker (2018) about About the European and US market, Ahmed and Ahmed (2019) about the Indian market, Chan and Zhang (2021) about the US market. In each case, the stocks with the highest ROE outperform their respective markets over time.

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We wanted to verify these results over the period from July 1, 2012 to March 3, 2023 in the US market. By taking the 50 listed companies with the best return on equity (ROE) in the S&P 500, we built an equally weighted portfolio of these 50 stocks. Arbitrations were regularly made to keep the 50 companies with the best ROE (and to remove those whose ROE was deteriorating).

Here is the performance from 2012 to 2023:

In blue: Portfolio of the 50 S&P 500 companies with the best ROE

In green: The S&P 500 broad index

The cumulative performance of this US portfolio over the defined period (just over 10 years) was 265.80% compared to 191.57% for the S&P 500.

The outperformance is also present when we do the same work on the European market. Over the same period (July 1, 2012 to March 3, 2023), we selected the 50 European companies in the STOXX Europe 600 index with the best ROE and we regularly updated this equally weighted portfolio in order to keep the highest ROEs in our selection. The difference is even more obvious in Europe between our portfolio and the broad European index, the STOXX Europe 600, which is known as one of the hardest European indices to beat.

Here is the performance from 2012 to 2023:

In red: Portfolio of the 50 STOXX Europe 600 companies with the best ROE

In green: The STOXX Europe 600 broad index

The cumulative performance of this European portfolio over the defined period (a little more than 10 years) was 207.03% against 80.53% for the STOXX Europe 600.

Our study confirms all previous studies. Although past performance does not predict future performance, owning companies with a high ROE gives you the chance to outperform the market in the long run.

That's why we offer an investment style list that ranks companies by ROE (from highest to lowest percentage), selecting only the best stocks based on this criterion of financial profitability.

Click here to discover the companies with the best return on equity