ROE, ROA and ROIC

A company that earns $100 million is far more impressive if it used $500 million of capital than if it needed $5 billion. Return measures show how efficiently a business turns the money invested in it into profit. Return on equity (ROE), return on assets (ROA) and return on invested capital (ROIC) are three of the most important. ROIC compared with the cost of capital is often considered the best single test of whether a company creates value.

The formulas#

NOPAT = operating income × (1 - tax rate)
invested capital = debt + equity - cash (or operating assets - operating liabilities)

Worked example#

The DuPont breakdown#

ROE can be split into three drivers:

ROE = (net income / revenue) × (revenue / assets) × (assets / equity)
     = net margin × asset turnover × equity multiplier

Two companies with the same ROE can be very different: one through high margins, the other through heavy debt. See Operating and Financial Leverage.

Why ROIC matters most#

• Value creation: a company creates value when ROIC exceeds WACC. Growth only adds value if new investments earn more than the cost of capital.
• Capital structure neutral: ROIC includes debt and equity, so it is not inflated by borrowing.
• Reinvestment and growth: growth = reinvestment rate × ROIC. A company earning 20% ROIC and reinvesting half its NOPAT can grow about 10% a year without outside capital. See Capital Allocation and Management.

Typical ranges#

Pitfalls#

• Buybacks and negative equity can make ROE extremely high or meaningless. See Debt, Cash and Shareholders' Equity.
• Goodwill: acquisitions add goodwill to invested capital, lowering ROIC. Analysts sometimes calculate ROIC with and without goodwill. See Goodwill and Intangible Assets.
• Expensed intangibles: companies that invest heavily in R&D and marketing may have understated invested capital and overstated ROIC.
• Cyclical peaks: returns look highest at the top of a cycle.
• Banks: ROA and ROE are standard; ROIC is not used for financial firms.

Returns and investing#

High and stable returns on capital are a core feature of "quality" stocks. Research on the quality factor has found that profitable companies with high returns on capital have historically delivered better risk adjusted returns than unprofitable ones. See Quality and Profitability Factors.

Frequently asked questions#

What is the difference between ROE and ROIC?#

ROE measures returns on shareholders' equity only; ROIC measures returns on all capital invested, including debt, so it is not inflated by leverage.

What is a good ROIC?#

One consistently above the company's cost of capital; sustained ROIC above about 15% to 20% often indicates a strong competitive position.

What is the DuPont analysis?#

A breakdown of ROE into net margin, asset turnover and financial leverage, showing what drives a company's return on equity.

Next, learn how to judge whether reported profits are reliable in Earnings Quality and Cash Conversion.