Return on invested capital (ROIC), return on equity (ROE), and shareholders return are three important metrics used to evaluate a company’s profitability and investment performance. By analyzing their definitions, differences, and relationships, investors can better understand a company’s financial situation and make informed investment decisions. The comparison of ROIC, ROE and shareholder return provides insights into capital structure, operating efficiency, valuation and more. In this article, we will take a deeper look at these three metrics, their implications, and how they interact with each other.
Definitions and key differences between ROIC, ROE and shareholders return
ROIC measures how efficiently a company uses capital invested in its operations and generates operating profit. It is calculated by dividing net operating profit after tax by invested capital. ROE measures how much net income a company generates as a percentage of shareholders’ equity. It is calculated by dividing net income by average shareholders’ equity. Shareholders’ return refers to the total return shareholders earn from capital appreciation and dividends. ROIC focuses on operating performance, while ROE evaluates profitability from the shareholders’ perspective. Shareholders’ return reflects their total investment gain. The key differences are that ROIC uses invested capital as denominator which includes both equity and debt financing, while ROE only accounts for equity financing. Shareholders’ return measures total investment gain rather than profitability ratios.
Why ROIC is a preferred metric over ROE for fundamental analysis
ROIC is often viewed as a superior metric compared to ROE in fundamental analysis for the following reasons:
1. ROIC measures returns against total capital invested, giving a more complete picture of capital efficiency. ROE only measures against equity capital.
2. ROIC is not distorted by financial leverage like ROE. A company can boost ROE by taking on more debt.
3. ROIC better evaluates operating performance and management capability since it excludes financing decisions.
4. ROIC enables comparison across companies with different capital structures. ROE varies greatly depending on leverage.
5. ROIC helps identify profitable investments and companies with competitive advantage that earn excess returns.
Relationship between ROIC, ROE and shareholders return
Although ROIC and ROE measure profitability from different perspectives, they are linked by the equity multiplier (assets/equity). ROE equals ROIC multiplied by the equity multiplier, demonstrating how financial leverage impacts ROE. Companies with higher financial leverage tend to have a higher ROE relative to ROIC. Shareholders’ return depends on ROIC and ROE, but also factors in valuations. A company with a high ROE but overvalued stock may provide lower shareholder returns. On the other hand, undervalued stocks can generate higher returns for shareholders. Thus while ROIC and ROE measure historical profitability, shareholders’ return reflects expected future investment performance.
Using ROIC and ROE together provides a more complete analysis
While ROIC is preferred for analyzing operating efficiency, ROIC and ROE together can provide a more comprehensive picture:
– Compare ROIC and ROE to assess whether high/low ROE is driven by operating performance or financial leverage
– Analyze ROIC trend over time to evaluate management execution
– Review ROE trend and volatility impacted by capital structure decisions
– Compare ROIC/ROE to cost of capital to determine value creation
– Use ROIC forecast to estimate future ROE based on target capital structure
Thus investors should analyze both ROIC and ROE to understand drivers of profitability and make better informed investment decisions.
In summary, ROIC, ROE and shareholders’ return provide important but different insights into a company’s profitability and investment potential. ROIC is preferred for operating efficiency while ROE evaluates financial leverage impact. Shareholders’ return reflects expected investment performance based on profitability and valuations. Analyzing the trio together can help investors make better informed decisions.