The return on invested capital (ROIC) and return on equity (ROE) are widely used measures to assess how efficiently a business is utilizing its investments in order to grow. Both ROIC and ROE are purely based on accounting numbers, making them very useful in measuring the efficiency of a company’s existing assets.
ROIC vs ROE: What's the Difference?
Both the return on invested capital and return on equity are fairly similar at their core as they try to measure the efficiency of a company’s investments based on profitability. However, ROE and ROIC as metrics are inherently different in the way that they measure profitability based on either the equity proportion of the firm or the total capital within the business.
Return on Equity
Return on equity measures the return on just the equity portion of a business. It puts the net income which is attributable for the equity holders of a company into perspective with the book value of equity within the firm. The formula for return on equity goes as follows:
Return on Invested Capital
The return on Invested Capital (ROIC) evaluates the return that is earned on the total capital (both attributable to equity investors and creditors) invested in the business. Return on invested capital is generally defined as the net operating profits after taxes divided by invested capital:
To calculate the ROIC of a company, multiply the operating income by 1 – the tax rate and divide that number with the invested capital of the business which is the sum of equity and debt minus cash:
Why do we use NOPAT?
We use net operating profits in the numerator of the formula since the return on capital measures returns that are both attributable to debt and equity holders. Net operating income after taxes (also known as NOPAT) represents the theoretical earnings that a company would have before any interest payments. As a consequence, to compute NOPAT, the reported operating income of the company is taken and multiplied by the firm’s tax rate.
Why do we subtract out cash in the denominator?
Since any interest income that a company earns on its cash is not included in the operating income figure in the numerator, we net out cash in order to be internally consistent in the calculation.
Example: ROIC and ROE of Microsoft Corporation
Since the return on capital consists of net operating profits after taxes divided by equity plus debt minus cash, we would need to have a look at the figures located in the income statement and balance sheet.
Microsoft reported an operating income of $52,959 billion for the fiscal year ending June 2020 and paid roughly 16.51% in taxes. Multiplying the operating income by 1 – the tax rate gives us a NOPAT of $44,215 billion.
Microsoft’s invested capital in June 2019 was $163,152B ($72,178B in debt plus $102,330B in equity minus $11,356B in cash).
Finally, dividing Microsoft’s net operating profit after taxes by the invested capital leads us to an ROIC of approximately 27,1%.
For the recent fiscal year ending in June 2020, Microsoft’s net income was $44,281 billion. Dividing the net income with the book value of Microsoft’s shareholder’s equity of $110,317 as of June 2019 leads us to a return on equity of 40,1%.
Please note that in both calculations of ROIC and ROE, we use the invested capital and shareholder equity reported at the beginning of the year due to the assumption that the recent profits are only attributable to the investments that were made at the start instead of during the course of the fiscal year.
ROIC vs ROE: Which Measure Should Be Used?
ROIC is generally considered more useful because the ROE rules out the debt component of a firm and thus becomes sensitive to actions that can heavily impact shareholder equity. Not including debt in the calculation also means that only ROE’s of companies with similar capital structures (mix of debt and equity) can be compared to each other.
Since, in its standard form, cash is not deducted from the denominator in the return on equity calculation, companies with huge cash balances will misleadingly have lower ROEs than firms with less cash.
That being said, deciding on which measure to use will primarily depend on the purpose for which it is needed. If you want to compare the capability of firms to generate returns on their capital with different capital structures, using the return on invested capital should be a solid option.
If you want to assess whether a firm is generating shareholder value or destroying value, you’d need to compare the ROE or ROIC with either the firm’s cost of equity or cost of capital (WACC). The higher the positive spread between ROE/ROIC and the cost of funding those returns, the more valuable a company will become as it grows.
The difference between ROIC and ROE lies in the fact that each of them attempts to measure the efficiency of a company’s investments from a different perspective. The return on invested capital takes the total capital within a firm that is raised by debt and equity into account, whereas the return on equity only focuses on the returns based on the equity portion within the business.