ROE — a cheap company and a good company are different things

What return on equity measures

ROE is net income divided by shareholders' equity: how much the company earned in a year on each 100 of capital shareholders left inside it.

An ROE of 15% means 100 of equity produced 15 of profit. Retain that profit and equity becomes 115; hold the same ROE and next year's profit is 17.25. That is why a business sustaining high ROE compounds its capital.

So ROE is both a profitability measure and a growth rate — net of what leaves as dividends, it approximates how fast the company grows on its own.

Breaking ROE into three parts

Two companies at 15% can get there by completely different routes. The classic DuPont decomposition splits ROE into net margin (profit/sales) × asset turnover (sales/assets) × leverage (assets/equity).

A luxury brand earns its ROE on margin; a large retailer earns a similar figure on thin margins and fast asset turns. The businesses are nothing alike, and the single number does not distinguish them.

The third term is the one to watch. Add debt and equity shrinks relative to assets, so ROE rises automatically — with no improvement in the business at all. Always read ROE beside the debt ratio, and note that buybacks lift it the same way by shrinking equity.

P/B = P/E × ROE

These are not independent numbers. By definition, P/B equals P/E times ROE: (cap/equity) = (cap/earnings) × (earnings/equity).

The identity says something blunt. A low P/B means the market is granting a low P/E, or the company earns a low ROE, or both. A business earning 5% ROE at a 10x P/E lands at 0.5x book. That 0.5x is arithmetic, not a discount.

Recover ROE to 20% and the same 10x multiple implies 2x book. Re-ratings of cheap stocks usually start with ROE moving, not with the multiple moving.

So the question to ask about a low-P/B stock is not 'why is this so cheap' but 'is there a reason ROE improves' — bigger shareholder returns, disposal of idle assets, a cyclical recovery: something that actually changes the numerator or denominator.

Checking it at the fund level

This is exactly where 'value' and 'quality' funds diverge. Value screens for low P/B and P/E; quality screens for high, stable ROE and low debt. The names sound adjacent and the holdings may barely overlap.

Telling them apart is easy: open the top holdings. Banks, holding companies and materials at the top usually means value; software, healthcare and consumer brands usually means quality.

The narrower the screen, the sharper the regimes in which it works and the stretches in which it lags. Knowing that going in — rather than buying the label — is what makes the holding period survivable.