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Dan Hung
Jonathan Goldberg
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Calculations of Return (ROA vs ROE vs ROIC)

October 09, 2009
Return on assets (ROA), return on equity (ROE) and return on invested capital (ROIC) are the three most prevalent metrics used to obtain an idea of the returns a company generates, and to compare this return generation to the company’s peers. While important information can be learned from each one of these metrics, there are some significant differences between them.

ROA, calculated as net operating profit after tax (NOPAT) divided by total assets, shows the returns the company is able to generate relative to its entire asset base. While generally a good metric to use in comparing companies in same industries, this metric can be skewed when a company is holding lots of excess cash or assets for sale. These assets, while not expected to generate income are used in the calculation thereby causing the return on assets to appear lower than that which the company’s actual productive assets generate.

ROE, calculated as net income after tax divided by total equity (excluding preferred shares), demonstrates the percentage return earned on each dollar invested by the shareholders of the firm. This metric is very relevant when comparing companies with similar capital structures but outside of such a scenario it should not be relied upon. As Assets = Liabilities + Equity, the more debt a company has in its capital structure the smaller the equity will be as a percentage of total assets. Unlike the ROA metric, which remains stable throughout all capital structures, ROE can appear extremely high or extremely low when comparing a company to another employing a very different percentage of debt to equity.

My personal favorite of the three is ROIC, calculated as NOPAT divided by ‘operating net working capital plus operating fixed assets’. Operating fixed assets are any assets that are expected to contribute to earnings such as equipment, land (if not excess), goodwill, intangible assets, etc. Using operating net working capital, calculated as ‘current assets’ minus ‘excess cash’ minus ‘current liabilities’, also ensures that current assets that aren’t expected to generate earnings (such as excess cash) are not included in the calculation. This metric is my favorite as it gives a good indication of a company’s actual capacity to generate returns through utilization of its productive assets. Also, this metric can be used to compare companies employing varying capital structures. My main use of this metric is in comparing it to a company’s weighted average cost of capital (WACC), an estimation of the return expected by the debt and equity holders of the firm on a weighted average basis. The purpose of comparing the two is described in a previous article.

Jonathan Goldberg, MBA

http://www.jonathangoldberg.com

About the author:

Jonathan Goldberg
The Curious Investor is a stock investing blog written by Daniel Hung. The blog's aim is to provide both educational and informational articles on stock investing concepts, strategies, and potential targets. The author hopes that these articles will allow him and others to make informed and profitable investment decisions. Further, he invites readers to respond via comments or e-mail and participate in constructive discussion. Daniel Hung started The Curious Investor as a student at Columbia University and it blossomed into a passion for investing and finance he hopes to share with others. He now works for a private investment fund in New York, NY. For more articles and tutorials please visit: http://thecuriousinvestor.com

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