Is a Company With Consistent 20%+ ROE Earnings Quality High?

Most retail investors assume that any company sustaining a 20 percent return on equity for years has rock-solid earnings quality. That belief is half-right and dangerous when you do not know how to read quarterly results of a company. ROE alone hides accounting tricks, debt-fuelled returns, and one-time gains that flatter the headline number.

This piece walks through the myth, the evidence on both sides, and a real example of two companies with identical 22 percent ROE but very different earnings quality. By the end, you will know exactly which filters to apply before trusting that ROE number.

The Myth: ROE Above 20 Percent Means Quality

Return on equity measures net profit as a percentage of shareholders' equity. A 20 percent ROE means the company earned 20 rupees of profit for every 100 rupees of capital that shareholders contributed.

The popular logic goes: if a company sustains 20 percent ROE for 10 years, it must be doing something very right. Strong moats, pricing power, efficient capital allocation. Buy and hold for life.

This is the foundation of much of Warren Buffett-inspired Indian investing literature. And it is partially true. But the same number can come from very different sources, only some of which are durable.

The Evidence That Supports the Myth

Plenty of high-quality companies do show consistent 20 percent plus ROE for decades. Page Industries, Asian Paints, Hindustan Unilever, and Marico in Indian markets fit the textbook quality template.

Compounders With Real Quality

These companies share a common pattern. Their earnings power comes from operating leverage — strong brand, distribution moats, modest capital reinvestment needs, and pricing power that exceeds inflation. Their balance sheets carry low debt. Working capital cycles are clean. Cash flow tracks reported profit closely.

If you check the quarterly results, you find consistent revenue growth, gross margin stability, and operating cash flow that matches or exceeds net profit. Nothing dramatic, just relentless steadiness.

The compounder's secret is boredom. The same growth, the same margins, the same dividend payout — quarter after quarter for 20 years. That repetition is the moat.

The Evidence Against the Myth — When 20 Percent ROE Lies

The trouble starts when you find a 20 percent ROE without these characteristics. The number is the same, but the source is shaky. Three common traps explain most of the false signals.

The Leverage Trap

ROE = Net Margin × Asset Turnover × Financial Leverage. The third term is the dangerous one. A company with a 5 percent net margin, a 2x asset turnover, and 2x leverage shows the same 20 percent ROE as a company with 12 percent net margin, 1x asset turnover, and 1.7x leverage.

The leveraged version's ROE evaporates the moment interest rates rise or the next downturn forces deleveraging. NBFCs and infrastructure companies often show this pattern. Their quarterly results read fine until the credit cycle turns.

The Buyback Trap

Aggressive share buybacks shrink equity. With less equity in the denominator, ROE rises mechanically even if profits are flat. Many large IT names in India and US have used this lever to keep ROE above 20 percent while underlying earnings growth has slowed considerably.

This is not necessarily bad — disciplined buybacks return cash to shareholders. But the ROE number alone does not tell you whether the underlying business is improving or simply being financially engineered.

The Asset Write-Down Trap

Every few years, a company writes off a chunk of goodwill or fixed assets. The write-down hits net income that quarter but reduces the equity base for future quarters. From the next quarter onward, ROE looks better even though no real improvement has happened.

This trick shows up clearly in quarterly results. Look for one-time impairment charges in the prior year, then compare ROE before and after. If ROE jumped without revenue growth, the write-down explains the jump.

Real Example: Two Companies, Same ROE, Different Quality

Consider two hypothetical Indian companies, each with a 22 percent ROE for the past 5 years.

Company A is a branded consumer goods firm. Its operating cash flow has matched or exceeded reported net profit every year. Debt-to-equity is 0.1. Capital expenditure has been roughly 30 percent of operating cash flow, with the rest paid out as dividends or held as cash. Quarterly results show flat-to-rising gross margins and steady working capital cycles.

Company B is an infrastructure financier. Its operating cash flow has been negative or flat in 3 of the past 5 years even as reported profit grew. Debt-to-equity is 4.5. Net interest margin has compressed each year, masked by aggressive borrowing growth. Quarterly results show rising provisioning that is repeatedly explained as one-time.

Same ROE. Vastly different earnings quality. Company A is a compounder. Company B is a credit cycle waiting to break.

Verdict: Use ROE With Three Filters

ROE is a useful starting filter, not an ending verdict. Before trusting any company with consistent 20 percent ROE, run these three checks every quarter:

1. Cash flow check — operating cash flow should track or exceed net profit over rolling 3-year periods. Persistent gap signals accounting concerns.
2. Debt check — debt-to-equity above 1.5 means a meaningful slice of the ROE comes from leverage. Strip leverage out by computing Return on Capital Employed (ROCE) instead.
3. Equity base check — has the equity base been shrinking through aggressive buybacks or write-downs? If yes, ROE may be inflating without underlying business improvement.

You can pull quarterly filings directly from BSE and NSE company pages, or check SEBI's central reporting portal at sebi.gov.in. Run the three checks every quarter for any holding above 20 percent ROE, and you will catch most quality issues before the market does. The number is not the answer. The story behind the number is.