Return on equity and ROIC: measuring how well a company uses capital

Two companies can both earn 10 million, but if one needed twice the capital to do it, it is the weaker business. Profit becomes far more meaningful when measured against the money used to make it. Return measures show how efficiently a company puts capital to work, and companies that earn high returns on capital year after year tend to create value for their owners. This article explains return on equity (ROE) and return on invested capital (ROIC), with examples, and where each can mislead.

Return on equity

ROE is net income divided by shareholders' equity. It answers the question: for each unit of money that shareholders have in the business, how much profit does the company make?

If a company earns net income of 100 on equity of 500, its ROE is 20%.

Why ROE can mislead

ROE can be raised without improving the business.

• Debt. Borrowing adds to assets without adding to equity. Take a second company with the same net income of 100 but equity of only 200 because it has financed itself with 600 of debt. Its ROE is 50%, which looks superior, but it is far riskier because of the debt.
• Buybacks. Repurchasing shares reduces equity, which can lift ROE. Some companies have negative equity after years of buybacks, which makes ROE meaningless.
• Write-downs and accounting changes can distort equity.

For these reasons, ROE should be read together with the balance sheet.

The DuPont breakdown

ROE can be split into three drivers:

ROE = net profit margin x asset turnover x financial leverage

• Net profit margin: profit divided by sales.
• Asset turnover: sales divided by assets, showing how efficiently assets generate sales.
• Financial leverage: assets divided by equity, which measures reliance on borrowing.

Two companies with the same ROE can reach it by different routes. A luxury brand might have high margins and low turnover. A supermarket might have low margins and high turnover. A highly leveraged company reaches it through debt. Breaking ROE down shows which route a company is taking, and how durable it is.

Return on invested capital

ROIC measures profit relative to all the capital that investors have put in, both equity and debt. This makes it harder to inflate with borrowing.

A common calculation:

• NOPAT (net operating profit after tax) equals operating income times (1 minus the tax rate).
• Invested capital equals equity plus debt minus excess cash.
• ROIC equals NOPAT divided by invested capital.

A worked example. A company has operating income of 150 and a tax rate of 20%, so NOPAT is 120. Its equity is 400, debt 300 and excess cash 100, so invested capital is 600. ROIC is 120 divided by 600, which is 20%.

Compare with the cost of capital

The key question is whether the return exceeds the cost of the capital used. The company pays interest on its debt, and shareholders expect a return on their equity. The blended figure is the weighted average cost of capital, or WACC. If WACC is 9% and ROIC is 20%, the company is earning 11 percentage points more than its capital costs, and is creating value with each unit it reinvests. If ROIC is below WACC, growing the business destroys value, however fast revenue rises.

What to look for

• Consistency. Look at the return over five to ten years. A company that earns high returns in one year may be at a cyclical peak. Steady high returns point to a durable advantage.
• The level relative to peers. Compare with direct competitors.
• Sustainability. High returns attract competitors. Ask what protects the company's profits: a brand, scale, switching costs, patents or a network effect.
• The ability to reinvest. The best case is a company that earns a high return and can invest more at the same high return. A company with a high ROIC but few places to reinvest will return cash to shareholders instead.

Cautions

• Very high ROE on a tiny or negative equity base is not meaningful.
• Intangible assets, such as brands and research, are often not fully on the balance sheet, which can flatter the returns of companies that have built them internally.
• Acquisitions add goodwill to invested capital. Comparing returns with and without goodwill can help.
• Returns depend on the accounting. Be careful about comparing across different accounting standards or industries.

Common mistakes

• Using ROE alone without checking debt.
• Looking at a single year.
• Comparing companies in different industries.
• Ignoring the cost of capital.
• Treating high past returns as a guarantee.

A short checklist

• I have checked both ROE and ROIC.
• I have looked at how much debt contributes to ROE.
• I have compared returns with peers and with the cost of capital.
• I have checked consistency over many years.

Look for businesses that consistently earn returns well above their cost of capital, and that can keep doing so. That combination is much of what separates great long-term investments from ordinary ones.