ROE vs ROIC: how they differ and which one to watch

ROE (return on equity) and ROIC (return on invested capital) both measure a company’s profitability, but on different bases. Confusing them can make you believe a business is better than it really is.

What each one measures

ROE divides net income by shareholders’ equity: how much the company earns per euro of shareholders’ money. ROIC divides operating profit after tax by all the capital employed (debt plus equity): how much it earns per euro invested in the business, wherever it comes from.

The ROE trap

ROE can be boosted simply by adding debt, because it shrinks the equity in the denominator. A heavily indebted company can show a spectacular ROE and still be fragile. ROIC is not fooled: it includes all debt in its calculation, so it reflects the real profitability of the business.

Which to watch

• Use ROIC to judge the real quality of the business, without the distorting effect of debt.
• Use ROE to see the return for shareholders, but always check the debt level.
• If ROE is far above ROIC, it is usually due to leverage: investigate.
• The ideal: high, stable ROIC with reasonable debt.