What is the Return on Equity Screen?
The Return on Equity Screen has no famous author behind it. It is a rules-based quality screen built around one number: return on equity, or ROE, a company's net income divided by its shareholders' equity. Shareholders' equity is what the owners have put into the business and left there — total assets minus every liability. ROE answers a direct question: for each dollar of owners' capital tied up in the company, how many cents of profit does management generate a year? A firm earning $100 million on a $300 million equity base earns about 33% on equity, which is excellent; the same profit sitting on a $3 billion base is barely 3%, which is poor. As a rough guide, ROE above 15% is good and above 20% is exceptional, though those figures only mean something once you compare them to the company's own industry.
The core idea: high and consistent ROE
A single strong year of ROE is easy to produce and easy to flatter. This screen rewards companies that post high returns on equity year after year, because durable, above-peer profitability is one of the clearer signals that a business owns a real competitive advantage — pricing power, a cost edge, a brand, something rivals cannot quickly copy. Consistency also has a practical payoff. With no dividend paid out, a company's sustainable growth rate equals its ROE, so a business that reliably earns 20% on equity can fund roughly 20% growth from its own profits, without diluting existing owners through new shares or piling on debt.
There is a trap, and the screen is built around it. ROE breaks into three parts: net profit margin (how much of each sales dollar becomes profit), asset turnover (how much sales the asset base produces), and financial leverage (how much of those assets is funded by debt rather than equity). Raising any of the three lifts ROE — including the last one. A company can manufacture a high ROE simply by carrying heavy debt and keeping equity thin, which flatters the ratio while quietly adding risk. So the screen refuses to take a high ROE at face value. It insists the profitability come from strong margins and efficient use of assets, and it caps how much debt the balance sheet carries.
What the Return on Equity Screen looks for
- Return on equity over the last 12 months, and in each of the last five fiscal years, greater than 1.5 times the industry median ROE for the same periods — the central test for high and consistent profitability against peers.
- Net margin over the last 12 months above the industry median, so the returns come from genuine bottom-line profitability.
- Asset turnover over the last 12 months above the industry median, a check that the company uses its asset base efficiently.
- Total liabilities to total assets in the most recent quarter below the industry median — the leverage check that stops debt from masquerading as quality.
- Earnings-per-share growth positive over both the trailing 12 months and the last five years, and above the industry median in each period.
- Sales growth positive over both the trailing 12 months and the last five years, and above the industry median in each period.
- Over-the-counter stocks, ADRs, and the miscellaneous financial services and real estate operations industries are excluded.
Notice the design choice: rather than screen for an absolute ROE above 20%, the rules ask for 1.5 times the industry median. That surfaces the strongest operators within each sector — a supermarket chain and a software firm have very different natural returns on equity — instead of simply filling the list with whichever industries happen to earn high returns.
Why it can work
The rationale is the one Warren Buffett has returned to for decades: a business worth owning is one that earns a high return on the capital retained inside it, and compounds that advantage over time. High, sustained ROE tends to travel with the traits long-term investors want — reinvestment opportunities, internally funded growth, and management that allocates capital well. By tying every test to industry medians, the screen also avoids rewarding a company just for sitting in a structurally high-return sector, and instead isolates firms that out-earn their direct competitors.
What to keep in mind
The screen deliberately contains no valuation test. It finds quality, not cheapness, so nothing stops you from paying a rich price for a fine business — and overpaying for quality is still a way to lose money. High ROE also mean-reverts: outsized returns attract competition, and few companies hold them for a decade. Watch the denominator, too. Large share buybacks and past write-downs both shrink equity, which can inflate ROE with no real improvement in the underlying business. Treat the passing list as a shortlist of quality, then bring your own judgment on price and durability.
Sources
The three-part breakdown of ROE into net margin, asset turnover, and financial leverage is the classic DuPont analysis, long used in fundamental research.
American Association of Individual Investors (AAII) — Stock Investor Pro screen definition and commentary.