Return on invested capital (ROIC), return on equity (ROE), and shareholder returns are three important metrics used by investors and analysts to evaluate a company’s profitability and investment return potential. Though related, each metric measures a different aspect of a company’s performance. Understanding the key differences between ROIC, ROE and shareholder returns is crucial for making informed investment decisions. This article will explain what each return ratio measures, how they are calculated, their advantages and limitations, and when each is more useful. There will also be examples to illustrate their practical applications in equity analysis and valuation.
ROIC focuses on capital efficiency from all capital providers
Return on invested capital (ROIC) measures how efficiently a company generates profits from its total capital invested. The formula is:
ROIC = Net Operating Profit After Tax (NOPAT) / Invested Capital
Invested capital includes all interest-bearing debt and equity. So ROIC considers returns to both debt and equity holders.
ROIC shows how well the company uses capital from all sources to generate operating profits. A higher ROIC indicates better utilization of capital to earn profits. Companies with high ROIC are better at converting invested money into profits.
ROIC is useful for comparing capital efficiency between companies in the same industry. It can reveal management strengths in optimizing capital allocation. ROIC also helps estimate the maximum price to pay for acquisitions based on maintainable returns.
ROE focuses solely on returns to common shareholders
Return on equity (ROE) specifically measures the return earned on common shareholders’ equity. The formula is:
ROE = Net Income / Average Common Equity
ROE shows how much profit a company generates per dollar of common shareholder equity. A higher ROE means higher return for shareholders based on their investment in the company’s stock.
Unlike ROIC, ROE only accounts for returns to common equity holders. It ignores returns to other capital providers like preferred equity and debt. So ROE doesn’t fully reflect how well total capital is used.
ROE is useful for comparing profitability specifically for common shareholders between companies. It helps assess management’s ability to generate shareholder returns from invested equity.
Shareholder returns focus on total returns from stock price and dividends
Shareholder returns measure the total investment returns received by common shareholders. This includes both capital gains from share price appreciation and dividend income.
The total shareholder return (TSR) formula is:
TSR = (End Price – Begin Price + Dividends) / Begin Price
Shareholder returns reflect the actual realized returns received by shareholders from holding the stock over time. However, share returns depend on market sentiment and can diverge from business fundamentals.
Shareholder returns help assess the attractiveness of a stock for investors. Stocks with high historical TSR may continue generating high returns in the future. Shareholder returns also facilitate comparing different investment opportunities.
Key differences and applications of the return ratios
Though ROIC, ROE and shareholder returns all measure investment return, key differences exist:
– ROIC considers returns from total capital while ROE and TSR focus just on common equity returns
– ROIC and ROE measure return based on financial performance but TSR measures actual realized returns to shareholders
– ROIC and ROE can diverge from shareholder returns due to market sentiment
ROIC is best for comparing capital efficiency between companies. ROE is best for comparing shareholder return performance. TSR is best for evaluating actual realized returns for shareholders.
High-ROIC companies efficiently use capital but may not reward shareholders well. High-ROE companies return more profits to shareholders but may not deploy capital optimally. High-TSR companies have provided excellent returns historically but may not sustain them.
ROIC, ROE and shareholder returns provide valuable but distinct insights into a company’s profitability and investment return potential. Understanding the key differences allows investors to focus on the most relevant return metric for their analysis and make better informed investment decisions.