ROIC vs ROE

Return on Invested Capital (ROIC) measures a company’s ability to generate profits from its invested capital. It’s calculated by dividing net operating profit after taxes (NOPAT) by invested capital.

ROIC = NOPAT / Invested Capital

Invested capital includes debt and equity used to fund a company’s operations. ROIC provides a comprehensive picture of a company’s profitability, as it takes into account both the cost of debt and equity.

What is Return on Equity (ROE)?

Return on Equity (ROE) measures a company’s net income relative to its shareholder equity. It’s calculated by dividing net income by shareholder equity.

ROE = Net Income / Shareholder Equity

ROE indicates how efficiently a company is using its shareholder equity to generate profits. However, it only accounts for equity and ignores debt, which can be a significant component of a company’s capital structure.

A Worked Example

The difference clicks once you run the numbers. Imagine a company with $1,000 of invested capital: $600 of debt and $400 of shareholder equity. It earns $150 of operating profit after taxes (NOPAT) and pays $30 in interest, leaving $120 of net income.

ROIC = $150 / $1,000 = 15%.

ROE = $120 / $400 = 30%.

Same company, same year, two very different numbers. ROE looks spectacular because the company is levered: a small equity base supporting a larger operation. ROIC tells you the business itself earns 15% on all the capital put to work, regardless of how it was financed.

How ROE Fools You

Now imagine management borrows another $200 and uses it to buy back shares. Equity shrinks, debt grows, and the operating business is unchanged. ROE jumps, because the denominator got smaller, while ROIC barely moves, because the capital earning returns barely changed. Share buybacks and leverage can manufacture a rising ROE out of a flat business. This is the oldest trick in corporate finance, and it is why sophisticated investors start with ROIC and treat ROE as a supporting actor.

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Why is ROIC a better metric than ROE?

While both metrics have their uses, ROIC is generally considered a more comprehensive and accurate measure of a company’s profitability. Here’s why:

1. Accounts for debt: ROIC includes debt in its calculation, providing a more complete picture of a company’s capital structure and profitability.
2. Less susceptible to manipulation: ROIC is less prone to manipulation by management, as it’s based on NOPAT, which is a more stable and reliable measure of profitability.
3. Better for comparing companies: ROIC allows for more accurate comparisons between companies with different capital structures.

The Real Test: ROIC vs. Cost of Capital

The most important comparison is not ROIC versus ROE. It is ROIC versus the company’s cost of capital, roughly what it pays for its debt and equity blended together (WACC). If a company earns 15% ROIC and its cost of capital is 8%, every dollar it reinvests creates value. If it earns 6% against an 8% cost of capital, growth destroys value, and shareholders would be better off with dividends or buybacks. This is what Warren Buffett means when he praises businesses that can reinvest at high rates of return: high ROIC on incremental capital, sustained for years, is the closest thing to a compounding machine that exists in public markets.

How to use ROIC and ROE in your investment strategy

When evaluating a company’s performance, consider the following:

1. Look for high ROIC: A high ROIC indicates a company’s ability to generate strong profits from its invested capital.
2. But also be cautious of high ROE: A high ROE may be misleading if a company has a high debt-to-equity ratio. Consider ROIC to get a more comprehensive picture.
3. Compare to industry averages: Compare a company’s ROIC and ROE to industry averages to determine its relative performance.

While both ROIC and ROE are important metrics for evaluating a company’s performance, ROIC provides a more comprehensive picture of profitability.

By understanding the differences between these two metrics and using them in conjunction with each other, you can make more informed investment decisions and optimize your portfolio.