Unlock Huge Returns | Master ROE, ROA, and ROIC
Understanding capital allocation is an often overlooked, but crucial, skill.
Why should I care about capital allocation?
Understanding how a company uses capital is the most important investing skill you can have. It will decide a companies profitability and growth, so you better pay attention.
A business that can compound capital at 25% will turn into a 100x bagger in 21 years. This article helps you identify those companies and works as a framework you can refer to so you can make better decisions. It is not all encompassing but serves to teach the basics.
Who is in charge of capital allocation?
It is management's job to make efficient capital allocation decisions that create value for shareholders. This could mean hiring better leaders to make the company more productive. Moving money to R&D so a new product can release. Opening up more locations in new markets. Or even just boosting marketing spend to get the word out.
If leadership can efficiently use the money they have, you are looking at not only great management, but a great company. This type of company will generate more profits with less capital than their competitors. A good recipe for success.
Is management doing their job well?
Leadership is doing their job well if they are getting the best return available with each dollar.
I will not be able to pinpoint to the dollar how much better one decision was than another. So I shoot to be generally right. My framework for deciding how well capital is being allocated is as follows:
Find what returns the company has achieved in past years. (ROE/ROA/ROIC)
Look at the past 2-3 years and find how the cash earned was used. Was it used to pay off debt? Issue dividends? Buyback shares? Or retained?
Debt should be paid off when solvency is a concern or when its interest rate exceeds the expected return of other investments.
Dividends should be issued when all other options yield less than 9%. This benchmark is the average return from investing the dividends in the S&P 500.
Shares should be bought back when they offer the highest expected return. If the stock is undervalued and projected to return 15% per year, buybacks could be a smart move.
Retaining money should be done when it offers the highest expected return, which is often since companies can usually deploy capital at higher rates. However, they should only keep as much as they can effectively use.
It will be impossible to determine down to the dollar if capital was used perfectly, but you do want things to make obvious sense.
What are ROE, ROA, and ROIC?
ROE, ROA, and ROIC are return on equity, assets, and invested capital, respectively.
ROE measures income made from total equity. ROA measures income made from total assets. ROIC measures operating income, removing tax provisions, made from invested capital. ROE and ROA are straightforward, but let's look at ROIC.
ROIC takes into account all capital used to grow a business. This includes both the money brought in by the company, book value, and debt taken out. Once you have that total, we subtract cash. By definition, cash is not invested; it is sitting in cash which is why it needs removed.
When do you use ROE vs ROA vs ROIC?
ROE, ROA, and ROIC are useful metrics but should be used in different scenarios. To decide which to use look at where the driver of growth is. Is it coming from debt, earnings, intangible assets, or share sales?
If the growth is funded by a mix of debt and equity then ROIC, which takes both into account, is best.
If growth comes from intangibles like patents, copyrights, and brands, then ROA is most useful.
If debt and intangibles are not an important factor and ROIC is not available to use, like in financial companies, ROE will be more useful.
If a company funds its growth by selling more shares, it's a red flag. Management that relies on this or keeps diluting shareholders is probably not doing a good job. If the company’s share dilution is more than 3% per year without any new acquisitions, I avoid the company.
These rules are loose for a reason; some companies will be between options. Often, you will need to look at more than one of these metrics to get the picture of capital allocation.
Examples of Capital Deployment
First Example
Scenario: An insurance company that is expected, based on past performance, to generate 30% ROE. They have no leverage issues and a stock expected to return 10% per year.
The obvious answer for the company is they should keep every dollar they can deploy. Anything they don’t feel they can deploy, shares can be bought back. If they issued dividends and bought back shares, they'd underperform. They would give shareholders a 9%-10% return instead of 30% if they retained all the capital.
Second Example
Scenario: A construction business with a history of ROIC around 10%. They have high leverage and a stock expected to return 8% per year.
In this case, it makes sense to pay off debt. They should do it until leverage is not a concern. If there is any capital left over, retaining it would be the best option. If there are no good opportunities to invest the money, then every dollar left should be paid as a dividend.
It's now common for companies to buy back stock like it's going out of style. But it usually makes the least sense compared to other options.
Third Example
Scenario: A tech company selling branded products expected to have an ROA around 6%. They have no leverage issues and a stock expected to return 5% per year.
In this situation, there are no great options available. Ideally they would find a way to get better returns on their assets. But if none exist, then it would actually make sense here to pay every dollar as dividends.
Retained earnings would generate 6%. Buying back shares only generates 5%. They have no debt to pay. But, dividends paid to shareholders average a 9% return if invested in the S&P 500. Making dividends the best option.
These are oversimplified examples but it should be obvious when capital is used well. The best investor of all time, Warren Buffett, never made spreadsheets to get exact valuations. The idea should be so good you don’t need to.
When estimating future returns on capital, look at past performance and what drove it. Was it management quality? Industry tailwinds? Market cycles? Or company culture?
Often you can decide the driver by comparing the company to its competitors. If it stands out and the reasons for outperformance remain or are returning, future outperformance is likely.
If it feels impossible to decide if a company should keep capital. It is most likely out of your circle of competence. Even if you only understand one niche industry you can still make a fortune.
What are the limitations of ROE, ROA, and ROIC?
It is important to understand each of these metrics has limitations. There are situations where they do not work.
These metrics don’t apply to unprofitable companies. ROE, ROA, and ROIC measure profit on capital. Without profit, these indicators are not useful.
These metrics also don’t apply to companies undergoing mergers or acquisitions. The buyer often adds significant assets like goodwill after the purchase, distorting ROIC due to the increase in invested capital. Once the business is integrated, revisit these metrics. Meanwhile, focus on FCF or FCF yield to assess if the acquisition is generating more profits.
When using ROE, it's crucial to monitor leverage and changes in equity, as these can distort it. Increased debt can reduce equity and if income remains stable it would falsely suggesting greater capital efficiency. ROA and ROIC are less easily distorted, but be cautious of accounting manipulations.
Summary
Understanding how a company uses its capital is the most important investing skill. A company that can reinvest its profits at a high rate of return continuously can grow exponentially.
Management is the steward for capital allocation. If they can effectively use the money they have, you are looking at not just a great management, but a great company.
Key Metrics for Capital Efficiency:
ROE: Measures how well a company uses its equity to generate income.
ROA: Measures how well a company uses its assets to generate income.
ROIC: Measures returns on both equity and debt capital.
When to Use ROE vs ROA vs ROIC:
Use ROIC when growth is driven by both debt and equity.
Use ROA when growth relies on intangible assets.
Use ROE when debt and intangibles aren’t a significant factor to growth.
Avoid the company if growth is mainly funded by share issuance.
Keep in mind this framework has its limitations. It will not work for unprofitable companies at all. Companies performing M&A could have distorted metrics. And when using ROE the equity base can be distorted. Giving a false sense of great efficiency.
By using this framework, you'll quickly spot great companies versus mediocre ones. This skill can lead to huge returns over your lifetime. Just look at Warren Buffett. Getting good at this can help you make smart investment choices and see impressive growth in your money over time.