I previously wrote an article on measuring a company's return on invested capital (ROIC). Looking at a company's return on equity, or ROE, also might be useful.
What's the difference?
The key difference is that it's much easier for a firm to increase its ROE through the use of debt than to increase its ROIC. This should be obvious, because whereas the ROE measures the return on equity capital only (as in equity, not debt), ROIC measures the return on all invested capital, including debt-financed capital.
How to calculate?
For return on equity, we simply take a firm's return, or its latest net income, and we divide by its equity. Equity, like homeowner's equity for a residence, is simply assets minus liabilities, or net worth. Thus, we can define ROE as Net Income/(Assets - Liabilities).
In general, I much prefer firms with high ROICs to those with high ROEs, because I don't like the fact that ROEs tend to increase with leverage (debt). With a high ROIC, it's much more likely that the company is earning high returns the old fashioned way, without the use of too much debt.
However, this isn't to say that ROEs aren't useful. For one thing, ROEs are much easier to calculate than ROICs. Also, sometimes using debt is just a fact of life. For example, when you buy a house, you're buying the equity in the house. If you were to buy the house as an investment property to rent out, because the investment will be heavily leveraged with a mortgage, you'd be more concerned with the return on equity -- or the return on the portion you, not the mortgage company, financed.
Because many financial service firms, such as banks and insurance companies, are primarily financed through the use of debt and other liabilities, it's very useful to compare their ROEs. Also, if you spot a company with a consistently high ROE, that's a pretty good indication that that company might be worth doing more homework on. For example, three stellar performers in the financial services sector, Wells Fargo (NYSE:WFC), U.S. Bancorp (NYSE:USB), and Markel (NYSE:MKL), sport 20%, 23%, and 25% ROEs, which puts them near the top of their industries.
ROE is a good tool that helps to measure a company's ability to earn returns on shareholder capital. When judging a company's ROE, investors should also take care to note how a firm's ROE compares to peers, whether the ROE is consistently high, and how much leverage is used to achieve the ROE.
If you enjoyed this article, you might also want to check out this article on using the P/E ratio, and this one on the P/B ratio.
U.S. Bancorp is an Income Investor recommendation.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. The Motley Fool has a disclosure policy.
