The difference between owning and loaning
When we were talking about home ownership earlier, we included the following equation:
- My House = My equity + The bank's loan
It's tempting to rephrase this as:
- My House = The piece I own + The piece the bank owns
But this common mistake glosses over a very important distinction -- the difference between what it means to own equity and what it means to own a loan.
Here's the deal: If you take out a mortgage to buy a home, you own the home. Period. It's all yours. With this ownership comes all the associated risk and reward. Should your home appreciate in value, all the appreciation is yours. The bank gets zip. Conversely, should your home depreciate in value, the loss is all yours. The bank won't reduce your loan balance accordingly.
What the bank owns is a mortgage loan with a home as collateral. The difference is not just semantics. To make this as clear as possible, let's bring in the world of corporate finance.
Your home ownership is equivalent to owning shares of stock. Like the stock market, home values tend to rise in the aggregate over the long run, but there is no guarantee that an individual home (or neighborhood) will rise in value, and short-term markets can be highly volatile. Moreover, your use of a home mortgage is equivalent to a brokerage margin loan, a vehicle for inflating your gains in good times (you make money off of the bank's money) and inflating your losses in bad times (you lose the bank's money on top of your own).
On the other side of the coin -- from the bank's perspective -- your mortgage behaves like a simple corporate bond. It returns a regular fixed interest payment that is independent of your home's market value, and it goes away when the debt has been paid in full, with no long-term ownership implications.
(If you start missing payments, however, the bank can step in and take your home to protect its investment. The same is true in the corporate world, where bond holders and other creditors get first dibs on corporate assets when bankruptcy is declared, with the equity owners (shareholders) typically getting nothing.)
Why bother delving into this fine point? What does it have to do with ROA versus ROE? Well, I can't speak for everyone, but a clearer understanding of this distinction -- between owning equity and owning a loan -- has bolstered my grasp of the fundamental accounting formula. It makes it crystal clear, for example, why such a formula is so useful in the first place. And as my depth of balance sheet understanding improves, ROA versus ROE gets clearer and clearer.
What about ROIC?
Return on Invested Capital (ROIC) is a more complex topic, beyond what we can easily cover here. We can make two relevant points, however, that spring naturally from our comparison of ROA and ROE:
- As we saw in our examples, debt is the "slider" that determines whether equity will differ from total assets and by how much. Invested capital doesn't ignore debt as equity does, nor does it necessarily include (the fruits of) all debt, the way total assets does. So when debt is present, invested capital will fall somewhere between assets and equity. This debt "slider" concept overlooks ROIC complexities in the numerator (the return part), but it gives a useful range for the denominator -- the invested capital.
- Computation of ROIC is usually a more complex process that separates out the business engine from the cost of the capital invested to build the engine. Typically, debt interest payments are removed from the net profit calculation to get a more direct read on the "business engine." The soundness of the engine is then compared to how much the company is spending to get their hands on the required investment capital -- a combination of simple debt interest charges and the famously elusive cost of equity capital.
Where to now?
With this basic overview under your belt, there are two very useful next steps you are now prepared to take:
1. Read about the Dupont Equation, which breaks down Return on Equity further into revealing component pieces.
2. Really dig in and take on the details of Return on Invested Capital.
Darn the numbers, Paul Commins thinks the execs at OUCH are doing an excellent job. Had he offered opinions on any real companies in this article, you could have checked his profile to see if he owned stock in any of them, in line with the Fool's disclosure policy.