Why ROE Gets Misread
Return on equity is widely used and widely misunderstood. Damodaran's position is that ROE is a measure of business quality, not a measure of valuation — and confusing the two leads to some of the more persistent errors in investing, particularly in low-price-to-book value strategies.
The Building-Block Example
Consider two businesses, each started with $60 million of equity:
- Business A generates $15 million of net income per year in perpetuity.
- Business B generates $3 million of net income per year in perpetuity.
ROE follows directly:
- Business A: $15M / $60M = 25% ROE
- Business B: $3M / $60M = 5% ROE
Whether each earns excess returns depends on the cost of equity. If the cost of equity is 10%:
- Business A earns 15 percentage points above its cost of equity — a value creator.
- Business B earns 5 points below its cost of equity — a value destroyer.
ROE minus cost of equity is the excess-return measure that actually matters. ROE alone, without the cost-of-equity comparison, tells you nothing about value creation.
What the Market Pays
Assume both companies are efficiently priced. At a 10% cost of equity, a perpetuity of $15 million is worth $150 million, and a perpetuity of $3 million is worth $30 million.
Converting to price-to-book ratios:
- Business A: $150M / $60M = 2.5x book
- Business B: $30M / $60M = 0.5x book
This is the uncomfortable result for low-P/B investors. The low price-to-book ratio is the market correctly identifying a bad business. Business B trades at half of book because it's destroying half of the book value every period. Buying it doesn't mean you've found undervaluation — it means you've found a business whose economics the market has correctly recognized.
A naive screen for low P/B will systematically produce a portfolio of Business Bs.
Good Company vs. Good Investment
The distinction matters. A good company earns returns above its cost of capital. A good investment pays less than intrinsic value. The two don't always overlap:
- Good company, bad investment: High-quality business trading well above intrinsic value.
- Bad company, good investment: Low-quality business trading well below intrinsic value (rare but possible).
- Good company, good investment: High-quality business at a reasonable price. The hardest to find.
- Bad company, bad investment: The low-P/B trap.
ROE helps identify business quality. It doesn't tell you anything about whether the current price is attractive.
ROE's Limitations
Several well-known issues:
- Accounting comparability. Depreciation policies, asset write-ups, and goodwill treatment make ROE numbers less comparable across firms than they look.
- Asset aging. Older asset bases tend to show inflated ROE as depreciation reduces book equity.
- Fair-value accounting. Fair-value adjustments flow through equity and distort year-over-year comparisons.
- Growth companies. Businesses reinvesting heavily understate ROE in the near term; the returns show up later.
- Buybacks. Companies that have repurchased large amounts of stock can show inflated ROE because book equity has been reduced.
ROE is therefore a starting point, not a conclusion. It needs a quality overlay (sector, accounting regime, lifecycle stage) before it means much.
Exiting Bad Businesses
One practical implication: the hardest thing in running or owning a bad business is exiting it. Sunk costs, employee and community commitments, and management's reluctance to admit the thesis was wrong all work against exit. The best time to exit is usually earlier than it feels comfortable.
Bottom Line
ROE is a quality lens. Excess return (ROE minus cost of equity) is the value-creation lens. Low price-to-book ratios aren't a free lunch — they're often the market's verdict that the business is destroying value. A lazy value screen that ignores the distinction systematically produces bad businesses at what look like cheap prices.