Return on invested capital (ROIC), return on capital employed (ROCE), return on equity (ROE), return on asset (ROA) and return on investment (ROI).
How many of these “Rs” have you heard before? And are you often confused by these terms?
Well, I sometimes do.
They are all return on “something.”
But what do they really measure? And should I even care as an investor?
Hold your horses! Let me break down the key differences as simply as I can.
The first R: ROIC
ROIC evaluates how well a company generates returns from the capital it has invested in its operations.
It answers the question, “What is the total after-tax profit the company generates for its investors using all invested capital?”
The keywords here are “after-tax profit” and “invested capital.”
ROIC uses net operating profit after tax (NOPAT) instead of net income. NOPAT is a measure of profit that does not subtract interest and it is the return that the company obtained for both its debt and equity holders.
As for invested capital, we subtract cash from the equation to avoid discrepancies in cash balances among different companies.
The main difference between ROIC and ROCE is the type of capital used.
Invested capital is a subset of capital employed, which includes all aspects of capital in a business such as debt and equity. Invested capital specifically refers to the active capital in circulation, excluding non-active assets like external securities and cash.
Therefore, the scope of ROCE is wider than ROIC as it considers all the capital used. ROCE is significant for company management, while ROIC is significant for investors.
What if, as an equity investor, I only want to focus on equity?
Answer: ROE
It looks at how much a business earns to the amount of equity put into it.
However, ROE can be inflated by reducing shareholder equity, such as write-downs or share buybacks, without necessarily increasing the net income.
Another drawback of ROE is that a company can employ excessive leverage despite the potential risks involved.
While ROE looks at the equity portion, ROA looks at the total assets a company holds.
Current and non-current assets are two primary asset categories. Current assets include cash and assets convertible to cash within a year, while non-current assets cannot be converted into cash within a year or at all. ROA considers both types of assets.
Total assets are also different from invested capital and capital employed.
This makes ROA particularly useful for commercial banks and insurance companies that rely entirely on their balance sheets to generate revenue.
Now that you have a better understanding of these four ratios, let's see how we can use them effectively.
To derive meaningful insights, you need to track the trend of these ratios over a period of time to assess the company’s potential and consistency.
It would help if you also compared these ratios within the same industry. This comparative analysis will gauge a company's performance relative to its peers and industry standards.
As for ROI, it is very different from the rest.
ROI measures the gains achieved by comparing the profits of an investment to its cost. It solely focuses on a single activity.
Another difference is that ROI does not adhere to a specific standard timeframe for calculations while the rest is usually computed over a 12-month duration.
So, what do I use?
The two most common ratios I used in my fundamental analysis are ROE and ROIC.
When assessing ROE, I emphasize comparing it to the industry standard and evaluating its consistency over a minimum period of 5 years.
For ROIC, I follow a similar approach but with an added criterion: ensuring that it surpasses its weighted average cost of capital (WACC).
This step allows me to understand if the company is generating returns that exceed its cost of capital, indicating favourable investment prospects.
Please let me know if this clarifies the five “Rs” by commenting below!
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