ROIC vs ROE: How to Compare Returns for Bursa Stocks

What do ROE and ROIC each measure?

Return on equity (ROE) divides net profit attributable to owners by shareholders’ equity. Our ROE glossary entry covers the basics.

Return on invested capital (ROIC) divides net operating profit after tax (NOPAT) by invested capital, typically equity plus borrowings, less surplus cash. It asks how well the whole business uses the money supplied by both owners and lenders.

Profitability measures such as these are core tools in financial analysis ^[1]. There is no single official ROIC formula, so companies and analysts define it differently. State your definition whenever you quote it.

Why can the two tell different stories?

Leverage is the main reason. If a company funds itself with more debt, equity shrinks relative to profit, and ROE rises even when the underlying operations have not improved. ROIC treats debt and equity together, so it is less affected by the financing mix.

Worked example (hypothetical)

These figures are hypothetical. “Company A” and “Company B” are not real companies.

Company B shows a far higher ROE, yet both businesses earn the same return on the capital they employ. The difference comes entirely from borrowing, and Company B pays much more interest for it. Higher ROE here comes with higher financial risk.

How do I use this for a Bursa company?

• Pull net profit, operating profit, tax, equity and borrowings from the income statement and balance sheet. Malaysian listed companies report under MFRS, set by the Malaysian Accounting Standards Board ^[2].
• Calculate NOPAT as operating profit less tax at the effective rate.
• Compute ROIC and ROE on the same period basis, preferably using trailing-twelve-month figures (see TTM versus quarterly).
• Compare the two. If ROE sits far above ROIC, check gearing before celebrating.

Also compare ROIC with the company’s cost of capital where you can estimate it. A business that earns less on invested capital than it pays to raise it is not creating value, however high its ROE.

What are the common pitfalls?

• Negative or tiny equity. After large losses or buy-backs, equity can be very small, making ROE huge and meaningless.
• Goodwill and acquisitions. Large goodwill inflates invested capital and depresses ROIC after takeovers.
• Cyclical peaks. A single strong year can mislead. Look at several years.
• Banks and insurers. Debt is raw material for them, so ROIC is rarely used. ROE and ROA are more common in the financial services sector.

A practical reading routine

Build a small table for each company you study with five years of ROE, ROIC and gearing side by side. Look first for stability: returns that hold steady through a full business cycle are more informative than a single peak year.

Then ask what drives the return. Margins, asset turnover and leverage each play a part, and separating them shows whether a business earns its returns through pricing power, efficient use of assets, or borrowing. A company whose ROIC rises because margins improve is in a different position from one whose ROE rises because share buy-backs shrank equity.

Last, remember that both ratios are backward-looking. They summarise what the business has already earned, using accounting values that may be far below or above the current worth of the assets. Treat them as tools for understanding quality and comparing peers, not as forecasts.

What mistakes do people make when comparing ROIC and ROE?

The first mistake is comparing ROIC figures from different sources without checking the definition. Invested capital can be built from the financing side, equity plus borrowings, or from the operating side, and each treats cash, leases and minority interests differently.

The second is judging ROE on its own when equity is small. A company that has returned a lot of capital or accumulated losses can show a high ROE simply because the denominator is tiny. The third is ignoring the tax rate applied to operating profit: a normal rate and the actual rate paid can give different answers, so state which one you used.

The fourth is expecting the two measures to agree. They answer different questions, one for owners and one for all capital providers, and the gap between them is itself informative about how much leverage is at work. Read both over several periods, because a single year can be distorted by one-off items.

Frequently asked questions

Sources

1. CFA Institute — overview of financial analysis techniques including profitability and return ratios
2. Malaysian Accounting Standards Board — issuer of the Malaysian Financial Reporting Standards

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