Investment Research, Valuation


On why ROIC instead of ROE/ROA:

ROE and ROA are distorted due to differing debt levels and tax rates. It does not allow you to measure the true underlying “returns generating capability” of the company.

Quoting an example from Greenblatt’s book, you can imagine that you can have Company A that has no debt, and Company B that has $50 in debt. The price of Company A is $60. The price of Company B is $10 per share. These two companies can have the same sales, operating earnings, enterprise value, etc. That is, it costs the same to purchase each company, and you get the same operating earnings, However, Company B will have a higher ROE than Company A because it took on more leverage. Hence even though both companies are “as capable” in generating returns, using ROE distorts the measurement due to leverage. To find good companies, we should target those with good ROIC/ROC instead.

On Not subtracting “excess cash” when calculating Invested Capital:

I guess excess “cash” do not literally mean cash cash. For example in the case of Microsoft, Berkshire Hathaway, or companies that have built up a “cash” hoard, most of those cash are in some short-term investments.

In those cases, the cash-equivalents might be earning a rate of return greater than what general shareholders could’ve earned, and those returns are not earned from the main operations of the company.

As such, I think those excess cash should still be subtracted, so that we can measurely accurate the “returns generating capability” of a company from its normal main operations.

On Moving across Capital Structures:

Those two companies are indeed equivalent. For example, you can buy Company A at $60, and then borrow $50. What you end up with is Company B. Similarly, you can buy Company B for $10, pay down the $50 debt, and end up with Company A. In a simplistic sense, a company can ‘move around’ capital structures. The thing that allows you to see that the two companies are “essentially equivalent” in terms of returns generating capability, is that the enterprise value for both are the same, and the EBIT for both are the same.

I agree that taking on leverage will have a tax benefit, and can improve your results in good times, and worsen your results in bad times. However, when we want to determine the true “returns generating capability” of a company (i.e. what is the returns that the company can generate using its assets (don’t confuse this with equity)), then we need to take leverage out of the equation to prevent distortion as previously explained.

You can think of it as a 2-step process:

  1. First, is to determine the fundamental returns-generating capability of companies. That will result in a tie between Company A and Company B (i.e. same gross profit using the same amount of assets).
  2. Next, you can look at the amount of leverage the 2 companies are taking on. Whether the company is consistently making more than its cost of capital, if so, then the company might be a better buy. Or whether the company is making less than its cost of capital, then even though the P/E is low due to the leverage, it may not be a good buy, etc.

As a final note, it is good to emphasize that the yardstick to use, to compare against a company’s Cost of Capital, is the ROIC. If ROIC > Cost of Capital, then growth is constructive/additive. If ROIC < Cost of Capital, then growth is destructive.



  1. Pingback: ROC vs ROE vs Return on NTA: a re-visit « Journeys of a Bumbling Investor - July 11, 2007

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