- 1ROE = Net Income ÷ Shareholders' Equity
- 2ROIC = After-Tax Operating Income ÷ Invested Capital (equity + debt - cash)
- 3ROIC is more reliable because it accounts for debt
- 4ROE can be artificially inflated by high leverage
- 5For comparing companies with different capital structures, always use ROIC
#The Formulas
Return on Equity (ROE)
ROE = Net Income ÷ Shareholders' Equity
Measures how much profit the company generates for every dollar of shareholder equity.
Return on Invested Capital (ROIC)
ROIC = NOPAT ÷ Invested Capital
Where: - NOPAT = Net Operating Profit After Tax (operating income × (1 - tax rate)) - Invested Capital = Total Equity + Total Debt - Cash
Measures how much operating profit the company generates for every dollar of total capital employed.
#Why ROE Can Be Misleading
ROE has a critical flaw: it can be boosted by adding debt.
Example: Two Identical Businesses
| Metric | Company A | Company B |
|---|---|---|
| Operating Income | $100M | $100M |
| Debt | $0 | $500M |
| Interest Expense | $0 | $25M |
| Net Income | $100M | $75M |
| Equity | $500M | $200M* |
| ROE | 20% | 37.5% |
| ROIC | 20% | ~14% |
*Company B used debt to buy back shares, reducing equity
Company B looks more "profitable" by ROE — but it achieved this by loading up on debt, which actually reduced the return on total capital.
#DuPont Decomposition of ROE
You can break ROE into three components to understand what's driving it:
ROE = Net Margin × Asset Turnover × Equity Multiplier
| Component | Formula | What It Shows |
|---|---|---|
| Net Margin | Net Income ÷ Revenue | Profitability |
| Asset Turnover | Revenue ÷ Assets | Efficiency |
| Equity Multiplier | Assets ÷ Equity | Leverage |
If ROE is high primarily because of the equity multiplier (leverage), the profitability is fragile. If it's high because of margins and turnover, it's genuine.
#When to Use Each
| Situation | Use ROE | Use ROIC |
|---|---|---|
| Comparing companies within same industry, similar leverage | ✅ | ✅ |
| Comparing companies with different debt levels | ❌ | ✅ |
| Evaluating management's capital allocation | ❌ | ✅ |
| Banks and financial institutions | ✅ | ❌ |
| Quick profitability check | ✅ | ❌ |
| Determining if growth creates value | ❌ | ✅ |
Special Case: Banks
For banks, equity IS the invested capital (they don't have traditional debt/equity structures). ROE is the standard profitability metric for financials.
#ROIC and Value Creation
A company creates value when ROIC > Cost of Capital (WACC).
| Scenario | Implication |
|---|---|
| ROIC > WACC | Every dollar reinvested creates more than a dollar of value |
| ROIC = WACC | Growth neither creates nor destroys value |
| ROIC < WACC | Growth actually destroys shareholder value |
This is why ROIC is the gold standard for evaluating whether a company's growth is actually beneficial.
#What Good Looks Like
| Metric | Poor | Average | Good | Excellent |
|---|---|---|---|---|
| ROE | < 5% | 10–15% | 15–20% | > 20% |
| ROIC | < 5% | 8–12% | 12–18% | > 18% |
A company with 25% ROIC that can reinvest at those rates is a compounding machine — the type of business that creates extraordinary long-term wealth.
#How We Use Return Metrics
In our Profitability factor, we include both ROE and ROIC alongside gross and operating margins. This multi-dimensional approach captures profitability from every angle, without over-relying on any single metric that could be distorted.
Last updated: February 6, 2026