2.7. Returns on Capital
Lesson objective
Evaluate what the company earns from invested resources.
ROE relates profit to shareholders' equity. ROA relates profit to assets. ROIC attempts to measure operating return on invested capital. Each metric answers a different question and may be calculated differently.
A high ROE may reflect an excellent business, but it may also result from a small equity base caused by debt or share repurchases. Review leverage and cash flow before drawing a conclusion.
Consistency and the ability to reinvest at attractive returns are often more important than one isolated figure.
Profit is more useful when compared with capital required
ROIC ≈ NOPAT ÷ Invested capital
NOPAT ≈ Operating income × (1 − normalized tax rate)
Capital efficiency
Company A needs $500M of invested capital to produce $75M of after-tax operating profit: about 15% ROIC. Company B needs $1.5B for the same $75M: about 5%.
ROE = Net income ÷ Average shareholders' equity, but high debt or aggressive repurchases can shrink equity and mechanically raise ROE. Read returns on capital together with leverage and cash flow.
Essential terms
| Term | Practical meaning | |---|---| | ROE | Net Income relative to shareholders' equity. | | ROA | Profit relative to total assets. | | ROIC | Operating return on invested capital; formulas vary. |
In Finzati
Quality metrics and the Screener help compare profitability measures.
What you should remember
- Confirm the definition used for each return metric.
- Do not interpret ROE without reviewing debt and equity.
Practice
Find a company with a high ROE and determine whether leverage contributes to the result.