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Archive for the ‘ROIC versus ROE’ Category

I value a business using its Return on Invested Capital (ROIC) [1] because this profitability measure is independent of the business’s capital structure (the proportion of debt and equity). [2] A business’s Return on Equity (ROE) is not. I think the valuation of a business should be independent of its capital structure because the business’s value rests on the earnings it makes on the assets it uses, not on how it finances those assets. 

For example, a business can increase its ROE by using debt to buy assets. This will most likely increase the risk for the business’s equity holders. Increasing a business’s ROE, by increasing its debt, does not necessarily make the business more valuable because the return required for the equity holders must be higher to compensate for this greater risk. By comparison, if a business increases its ROIC it is undeniably more valuable.[3]  

Costantini explains this much better than I do when he says:  

 “Clouded thinking over debt and equity, assets and liabilities, of which the heavy use the ROE ratio is a prime example, is ubiquitous…

Suppose that an investor wanted to buy a property for rental income. Surely, he would wish to visit the property a few times, assess the surroundings, the amenities, the neighbours. He would make up his mind about a likely rent, the amount by which he could increase it every year, and then decide on a price that would make this investment worthwhile. Next would come haggling with the seller, and finally he would arrange financing. It would never occur to him to do it any other way especially not in the reverse of our suggested order. That is because the main object of this property buyer is to assess the growth and return prospects of an economic object, which demands an investigation of the asset side of the balance sheet. To this end, there is no relevant information on the liability side. On the other hand, suppose that our investor now wanted to investigate the market value of an economic object. The asset side is now not so useful.” [4]  

   


 [1] A business’s ROIC is its Return on Invested Capital. It tells you how profitable a business has been. It does this by telling you the amount of capital the business needed to produce its profit. 

 [2] Joel Greenblatt determines a business’s profitability by its return on tangible assets (ROTA). See, The Little Book That Beats the Market’, Joel Greenblatt, 2005. I measure a business’s profitability by its return on invested capital (ROIC). I prefer this measure because it shows you the business’s earnings as a proportion of all the assets of the business. The ROTA shows you the business’s earnings as a proportion of only the tangible assets of the business. 

[3] On a sustainable basis. 

[4] P57, Cash Return On Capital Invested: Ten Years Of Investment Analysis With The CROCI Economic Profit Model’, Pascal Costantini, 2006.

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