Key Metrics: Return on Equity and Return on Invested Capital

Continuing the key metrics series, we'll focus on two numbers: Return on Equity (ROE) and Return on Invested Capital (ROIC). I group these metrics together here because, as you'll see later, they can reveal similar aspects regarding a company and their management. They're also favorite metrics of both Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio), so it may not be a bad idea to further analyze them.

What are ROE and ROIC?

Per usual in the key metrics series I want to start with the calculations and the meaning behind them. We'll start with Return on Equity and use Apple (AAPL, Financial)Â as an example.

• Return on Equity – Pretty simple ratio that analyzes how much profit is generated for every $1 invested by shareholders as well as how well a company uses investment funds to generate earnings growth.
  • Calculation – Again relatively simple, just divide Net Income over Total Shareholders' Equity, or the average Total Shareholders' Equity over the last two years.
    • Net Income/Average Total Shareholders' Equity.
      • 50,678 / ((119,355 + 111,547) / 2) = 0.439 = 43.9%.
        • We use average total equity because we're comparing an income statement figure, which covers a time period of a year, to a balance sheet figure, which provides us with a snapshot.
• Return on Invested Capital – ROIC measures the return that an investment generates for those who have provided capital and how well a company generates cash flow relative to the capital it has invested in its business.
  • Calculation – Calculated by dividing net operating profit after tax over average invested capital. Invested capital is simply total equity + debt - cash.
    • NOPAT (Operating Income * (1 - Tax Rate)) / Average Invested Capital (Total Shareholder's Equity + Debt - Cash).
      • (66,864 * (1 - 25.75%)) / (((119,355 + (10,999 + 53,463) - 41,601) + (111,547 + (6,308 + 28,987) - 25,077)) / 2).
        • 49,646.52 / ((142,216 + 121,765) / 2) = 0.376 = 37.6%.

What do ROE and ROIC reveal?

Both ROE and ROIC are two decent return benchmarks that can be used on a variety of companies across many different industries. But they're also great ratios to judge management and competitive advantages by as well.

1. Management – Quality is just as important as value for margin of safety. After all, we want to invest in a great, not a bad business, at an appealing price. Return on equity is one way we can measure quality as it encompasses the three pillars of corporate management: profitability, asset management and financial leverage.

2. Competitive Advantage – We also want to make sure whatever company we're going to invest in has a sizable stranglehold on the market, commonly called a moat. And the best way to quantify a rather intangible concept is by measuring return on invested capital. While it's a relatively tough calculation (several sites have it already calculated for you including the (Y)OURPORTFOLIO Spreadsheet), it gives the investor a clear picture as to how management is utilizing capital and the company's "moat" to generate solid returns for shareholders.

How to use ROE and ROIC

That's all great, but how and why should we incoroporate these two metrics in our investing approach. For instance, how do you go about deciding if a moat even exists? More importantly, is the advantage significant and potentially long lasting? While you should use your knowledge of the industry and the company, ROE and ROIC are two metrics that can assist you along the way.

So what numbers should you be looking for? Well, for reasons I'll explain in a little bit, I not only want to see ROE and ROIC above 15%, I want to see a trend of at least five years of over 15% and preferably increasing. Now let me explain why.

To briefly review, return on equity measures profits per dollar of capital shareholders have invested while return on invested capital is the rate of return the firm makes on capital invested in itself. Munger has called this number the single best metric when it comes to determining if a competitive advantage exists. But both he and Buffett have stressed the importance of both these metrics so I figured maybe we should analyze them as well.

In fact, one of theirletters to shareholders, from 1987, mentioned they use two tests to determine economic excellence – the first being the company had to have 10 years of a return on equity greater than 20%, the second stating the company couldn’t have any year worse than 15%. As you can imagine, not many companies fit the bill. According to a Fortune Magazine study, only 25 firms out of 1,000 passed from 1976 to 1986. The most astonishing number is 24, as in 24 out of the 25 companies outperformed the Standard & Poor's 500 during that timeframe. And since ROIC is closely related, you should pay close attention to these metrics. They can tell you a lot.

Disclosure: Long AAPL.

Start a free seven-day trial of Premium Membership to GuruFocus.