{"id":2526,"date":"2012-01-09T16:38:18","date_gmt":"2012-01-09T21:38:18","guid":{"rendered":"http:\/\/www.credittrends.com\/blog\/?p=2526"},"modified":"2012-01-09T16:38:18","modified_gmt":"2012-01-09T21:38:18","slug":"return-on-equity-roe-pales-compared-to-return-on-invested-capital-roic","status":"publish","type":"post","link":"https:\/\/www.credittrends.com\/blog\/2012\/01\/09\/return-on-equity-roe-pales-compared-to-return-on-invested-capital-roic\/","title":{"rendered":"Return on Equity (ROE) Pales Compared to Return On Invested Capital (ROIC)"},"content":{"rendered":"

 <\/p>\n

I just heard an analyst from a leading firm state one of his primary metrics is return on equity.<\/p>\n

Return on equity is important is important only as it provides a reflection of the firm\u2019s return on capital.<\/p>\n

For an obvious case, look at Apple, whose ROE pales compared to its ROIC as the firm is extremely adept at deploying cash as well as using other firms assets. In fact its equity is mostly cash.<\/p>\n

If two firms have similar ROE, yet one has a higher ROIC, almost always go for the firm with the higher ROIC, as deploying cash into productive assets will yield higher free cash flows.\u00a0 Its cost of capital is also important, especially as it reflects its financial structure.<\/p>\n

In today\u2019s investment marketplace, where many firms are overflowing with cash, the ability to redeploy cash having a low after-tax tax yield into projects and assets having a high return on capital will, in most cases be value-adding opportunities. If the firm is unaware of, shy regarding acquisitions, has a high cost of capital, or whose opportunities are currently producing low ROIC,\u00a0 deploying cash into new projects may be questionable. Mere accounting manipulation-such as an asset write-down-will improve ROE, as will a share buyback, yet both activities will not improve \u00a0ROIC.<\/p>\n

It is for this reason why investors and analysts should measure and prefer the cash on cash return in their acquisition analysis, to which ROE has a back seat. Income from cash is not included in the return on invested capital (ROIC) metric.<\/p>\n

Example UPS<\/strong><\/p>\n

To calculate UPS\u2019s return on invested capital, I employ the definition espoused in Chapter 5\u00a0 of my book Security Valuation and Risk Analysis<\/em>, and the information contained in is 10K.<\/p>\n

ROIC =Free cash flow \u2013 Net Interest Income\/Invested Capital (Equity +Total Interest Bearing Debt +PV of Operating Leases-Cash +Marketable Securities).<\/p>\n

 <\/p>\n

UPS had produced normalized $2.9 billion in free cash flow from which we<\/strong><\/p>\n

exclude its $100MM in net interest income as we are seeking its return on capital<\/strong><\/p>\n

employed.<\/strong><\/p>\n

=2.9 -0.1\/6.78+ 9.87 +1.1-1.05<\/p>\n

=2.8\/16.7<\/p>\n

=16.8% excluding loss in comprehensive income<\/p>\n

=12.5% including loss on comprehensive income<\/p>\n

Incorporating operating leases into the denominator lowers UPS\u2019s ROIC by about<\/p>\n

6 percent. If the loss on comprehensive income (or part of it) were added back to<\/p>\n

shareholders\u2019 equity, the difference would have been meaningful. The<\/p>\n

company\u2019s ROIC is sufficiently above their weighted-average cost of capital<\/p>\n

(8.35 percent) to state that UPS most likely has many value-adding investments<\/p>\n

it could make.<\/p>\n

 <\/p>\n

This would not be as apparent by merely looking at its ROE.<\/p>\n

 <\/p>\n

Kenneth Hackel, CFA<\/p>\n

CT Capital LLC<\/p>\n

www.ctcapllc.com<\/p>\n

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  I just heard an analyst from a leading firm state one of his primary metrics is return on equity. Return on equity is important is important only as it provides a reflection of the firm\u2019s return on capital. For an obvious case, look at Apple, whose ROE pales compared to its ROIC as the […]<\/p>\n

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