When screening I look at both ROE and ROA, as it is instructive to see what capital structure is doing. When modelling, it is easy then to get to ROIC, as you just then take out non-interest bearing current liabilities I think.

(I had ROIC drummed into me decades ago, as I was trained according to "Valuation" by Copeland et. al.)

Hi @Invmum, I look at both ROE and ROIC. They are both useful.

ROE = Earnings (NPAT)/shareholder equity. Really, it is self explanatory. It tells you what your return is (as a percentage) on the equity you own in that business. You can use ROE across businesses to see where you can get the best return on YOUR equity. However, it is not quite as simple as this. You need to consider a number of other things also eg:

• DEBT - highly leveraged business are using additional borrowed capital to boost earnings. This will artificially increase ROE and increase company risk, especially as interest rates increase. I prefer businesses with no debt. However, not all debt is bad, especially when ROE is very high. Eg. Nick Scali used cash + loans (net debt to equity ratio of 28%) to by Plush, but historical ROE was 60% which leaves plenty of fat to cover interest and repayments and to reduce debt quickly. On the other hand ING has ROE of +40% but this is artificially boosted by a mammoth net debt to equity ratio of 240%. A huge risk in the current environment and one I wouldn’t touch for this reason.
• Impact of abnormals, depreciation etc on earnings. Need to consider the impact to see if earnings are real.
• Price to Book ratio. This is important for valuation. How much are you paying for YOUR share of equity in the business? The P/B ratio is generally much higher for a high ROE businesses. Eg REA has a ROE of 30% and P/B is 13.6. If ROE is high and P/B is low, you could be on to a cheap business. eg DDH has ROE of +20% and a P/B of 1.2 (ie share price is 81c and Book value is 71c/ share) DDH is also debt free. Seems like a good bet to me.

ROIC is the return on all sources of capital used in the business, including debt. If a business is leveraged ROE is generally higher than ROIC.

There is a good explanation here: https://breakingintowallstreet.com/kb/financial-statement-analysis/roic-vs-roe-and-roe-vs-roa/

Disc: Shares held in NCK and DDH.

Just another thing I forgot to mention on ROE in my last straw. ROE is even more useful when you look at the trend, including forecast ROE. The trend can be a good indicator of when to buy into, or get out, of a business. Here are the historical ROE trends for two ASX retailers:

I have owned both of these retailers in the last 3 years. One I have sold out of, while the other i have been accumulating, and is now in the top 10 by weight in my SMSF (and one of my largest holdings on Strawman). One is Kogan and the other is Nick Scali. Can you pick which chart belongs to which business?

I’ll be keeping a close eye on the second chart to see if that small dip in 2021 continues to trend down. That could be a signal to get out.

Cheers,

Rick

A new reasearch paper on ROIC and calculating it for those interested - article_returnoninvestedcapital.pdf (morganstanley.com)