Saturday, July 9, 2011

ROA vs. ROE vs. ROIC

The three ratios mentioned below are all used to determine the returns which a company generates and all of them have a slight distinction.  All of them are valuable and no single ratio should be used as a clear indicator of the overall prospect of a firm.

Return on Assets (ROA) is calculated as net income divided by total assets.  ROA is readily used to compare firms in the same industry and can show the efficiency of a firm in using its assets to generate earnings.  An analyst or investor would prefer this number to be higher because that would indicate that the company is earning more with less.  This ratio can be skewed very easily and can happen when a firm is holding on to excess cash or assets.

Return on Equity (ROE) is calculated as net income divided by shareholder’s equity.  Used in comparing firms with the same capital structure, ROE reveals the level of profitability which a firm realizes by the money which was given to them by equity investors.  One thing to remember is that preferred shares are not used in this calculation.

The ratio which is more informative than ROA and ROE is the Return on Invested Capital (ROIC) and is calculated as net operating profits after taxes (NOPAT) divided by invested capital.  ROIC tells an analyst how efficient the firm was in investing capital in profitable investments.  This invested capital can go into anywhere from buildings to other companies.  The one major downside to this ratio is that it doesn’t specify if the return is more from continuing operations or a single event.  The upside to this ratio is that it can be used to compare firms with different capital structures.

An analyst needs to measure ROIC against weighted average cost of capital (WACC) since WACC is the minimum rate of return that a firm needs to earn for its stakeholders.  One thing to look for is that when ROIC is greater than WACC, value is being created for the stakeholders.  When this ratio is less than WACC, value is being destroyed.  Rather than following the much publicized ROE and ROA ratios, investors should look at the spread between ROIC and WACC for a firm.  On very broad terms, a firm with a higher spread between ROIC and WACC tends to be more valuable than a firm with a lower spread.

- Saliq


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  2. "The one major downside to this ratio is that it doesn’t specify if the return is more from continuing operations or a single event."

    As far as I understand ROIC does a better job at this than any of the other ratios, therefore I would not put it as a major downside. When calculating NOPLAT (ROIC=NOPLAT-INV.CAP) you exclude non-operating income which is usually what causes non-recurring items. However, to be fair, there is always the possibility (however small) that your operating assets produce non-recurring income/expenses.

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