ROIC and ROE

"Time is the friend of the wonderful business; it's the enemy of the lousy business. If you're in a lousy business for a long time, you're going to get a lousy result, even if you buy it cheap."

Time is the friend of the wonderful business; it's the enemy of the lousy business. If you're in a lousy business for a long time, you're going to get a lousy result, even if you buy it cheap.

ROIC and ROE both measure how well capital is used, but different capital: one looks at all financiers, the other only shareholders.

ROE (Return on Equity) is net income divided by shareholders' equity: how well the capital shareholders put in is performing. ROIC (Return on Invested Capital) is stricter - it divides operating profit by all invested capital, equity plus debt - which is why it's the preferred measure for value investors: a company can inflate ROE with more debt without actually becoming more efficient, but it can't do that with ROIC.

A 15% ROIC in a single year says less than a 12% ROIC held steady for a decade: consistency over time is often more informative than the absolute level in a single year, because it points to a defensible competitive advantage rather than a favorable, temporary result.

A positive ROIC isn't enough on its own: it needs to be compared with the company's cost of capital, that is, the minimum return shareholders and lenders require to finance it. A company with an 8% ROIC and a 10% cost of capital is destroying value every year it grows, even though the number looks positive on its own.