Key Metrics: Return on Equity (ROE) & Return on Invested Capital (ROIC)?
Continuing the Key Metrics series, we’ll focus on two numbers: Return on Equity, or ROE, and Return on Invested Capital, or ROIC. I group these metrics together here because, as you’ll see later, they can reveal similar aspects regarding a company and their management. They’re also favorite metrics of both Warren Buffett and Charlie Munger, so it may not be a bad idea to further analyze them.
What Is ROE & ROIC?
Per usual in the Key Metrics series I want to start with the calculations and the meaning behind them. We’ll start with Return on Equity and use Apple as an example.
- Return on Equity – Pretty simple ratio that analyzes how much profit is generated for every $1 invested by shareholders as well as how well a company uses investment funds to generate earnings growth
- Calculation – Again relatively simple, just divide Net Income over Total Shareholders’ Equity, or the average Total Shareholder’s Equity over the last two years
- Net Income / Average Total Shareholders’ Equity
- 50,678 / ((119,355 + 111,547) / 2) = 0.439 = 43.9%
- We use average total equity because we’re comparing an income statement figure, which covers a time period of a year, to a balance sheet figure, which provides us with a snapshot
- 50,678 / ((119,355 + 111,547) / 2) = 0.439 = 43.9%
- Net Income / Average Total Shareholders’ Equity
- Calculation – Again relatively simple, just divide Net Income over Total Shareholders’ Equity, or the average Total Shareholder’s Equity over the last two years
- Return on Invested Capital – ROIC measures the return that an investment generates for those who have provided capital and how well a company generates cash flow relative to the capital it has invested in its business
- Calculation – Calculated by dividing net operating profit after tax over average invested capital. Invested capital is simply total equity + debt – cash
- NOPAT (Operating Income * (1 – Tax Rate)) / Average Invested Capital (Total Shareholder’s Equity + Debt – Cash)
- (66,864 * (1 – 25.75%)) / (((119,355 + (10,999 + 53,463) – 41,601) + (111,547 + (6,308 + 28,987) – 25,077)) / 2)
- 49,646.52 / ((142,216 + 121,765) / 2) = 0.376 = 37.6%
- (66,864 * (1 – 25.75%)) / (((119,355 + (10,999 + 53,463) – 41,601) + (111,547 + (6,308 + 28,987) – 25,077)) / 2)
- NOPAT (Operating Income * (1 – Tax Rate)) / Average Invested Capital (Total Shareholder’s Equity + Debt – Cash)
- Calculation – Calculated by dividing net operating profit after tax over average invested capital. Invested capital is simply total equity + debt – cash
What Does ROE & ROIC Reveal?
Both ROE and ROIC are two decent return benchmarks that can be used on a variety of companies across many different industries. But there also great ratios to judge management, and competitive advantages, by as well.
- Management – Quality is just as important as value for margin of safety. After all, we want to invest in a GREAT, not a bad business, at an attractive price. Return on equity is one way we can measure quality as it encompasses the 3 pillars of corporate management: profitability, asset management, and financial leverage
- Competitive Advantage – We also want to make sure whatever company we’re going to invest in has a sizeable stranglehold on the market, commonly called a moat. And the best way to quantify a rather intangible concept is by measuring return on invested capital. While it’s a relatively tough calculation (several sites have it already calculated for you including the (Y)OURPORTFOLIO Spreadsheet), it gives the investor a clear picture as to how management is utilizing capital and the company’s “moat” to generate solid returns for shareholders.
How To Use ROE & ROIC
That’s all great, but how and why should we incoroporate these two metrics in our investing approach. For instance, how do you go about deciding if a moat even exists? More importantly, is the advantage significant and potentially long lasting. While you should use your knowledge of the industry and the company, ROE and ROIC are two metrics that can assist you along the way.
So what numbers should you be looking for? Well, for reasons I’ll explain in a little bit, I not only want to see ROE and ROIC above 15%, I want to see a trend of at least 5 years of over 15% and preferably increasing. Now let me explain why…
To briefly review, return on equity measures profits per dollar of capital shareholders have invested, while return on invested capital is the rate of return the firm makes on capital invested in itself. Charlie Munger has called this number the single best metric when it comes to determining if a competitive advantage exists. But both he and Warren Buffett have stressed the importance of both these metrics… so I figured maybe we should analyze them as well.
In fact, one of their letters to shareholders, from 1987, mentioned they use 2 tests to determine economic excellence. The 1st being the company had to have 10 years of a return on equity greater than 20%, and the 2nd stating the company couldn’t have any year worse than 15%. As you can imagine, not many companies fit the bill. According to a Fortune Magazine study, only 25 firms out of 1,000 passed from 1976 to 1986. The most astonishing number is 24, as in 24 out of the 25 companies outperformed the S&P 5oo during that timeframe. And since ROIC is close related, you should pay close attention to these metrics, they can tell you a lot.
