ROE, ROIC, and Economic Profit Explained

Return metrics answer a single question: how efficiently does this business convert capital into profits? The difference between ROE, ROIC, and economic profit is what capital you measure and whether you account for the cost of that capital. Get this wrong, and you will overpay for leveraged earnings or miss genuine value creation. Get it right, and you have a durable filter for quality.

Why this matters: A company can report 20% ROE while destroying shareholder value if its cost of capital is 22%. The metric alone is not the answer; the spread over cost of capital is.

ROE: The Equity Holder's Return (And Its Limits)

Return on Equity measures net income relative to shareholders' equity:

ROE = Net Income / Shareholders' Equity

A company earning $500M in net income with $2.5B in shareholders' equity has:

ROE = $500M / $2,500M = 20%

The point is: ROE tells you how well management deploys the equity investors have contributed (and retained). But it ignores debt entirely, which creates problems for capital-intensive businesses.

DuPont Decomposition (Where Returns Actually Come From)

The DuPont formula breaks ROE into three drivers:

ROE = Net Profit Margin x Asset Turnover x Equity Multiplier

Or more precisely:

ROE = (Net Income / Revenue) x (Revenue / Assets) x (Assets / Equity)

This decomposition reveals the source of returns:

Worked Example: DuPont Analysis

Company A:

• Net Income: $120M, Revenue: $1,000M, Assets: $1,500M, Equity: $600M
• Margin: 12%, Turnover: 0.67x, Multiplier: 2.5x
• ROE: 0.12 x 0.67 x 2.5 = 20%

Company B:

• Net Income: $70M, Revenue: $1,000M, Assets: $1,000M, Equity: $333M
• Margin: 7%, Turnover: 1.0x, Multiplier: 3.0x
• ROE: 0.07 x 1.0 x 3.0 = 21%

Company B has higher ROE but achieves it through higher leverage (3.0x vs 2.5x). If you screen only on ROE, you miss this distinction. The durable lesson: decompose every ROE to understand whether it comes from operations or from balance sheet engineering.

ROIC: The Capital-Agnostic Return (Why It Matters More)

Return on Invested Capital measures operating profit relative to all capital employed (debt plus equity):

ROIC = NOPAT / Invested Capital

Where:

• NOPAT = Net Operating Profit After Tax = EBIT x (1 - Tax Rate)
• Invested Capital = Total Debt + Shareholders' Equity - Excess Cash (or equivalently: Net Working Capital + Net Fixed Assets)

ROIC strips out capital structure effects. A company with 80% debt and 20% equity faces the same ROIC calculation as one with no debt.

Worked Example: ROIC Calculation

Industrial Company:

• EBIT: $400M
• Tax Rate: 25%
• Total Debt: $1,200M
• Shareholders' Equity: $1,800M
• Excess Cash: $200M

NOPAT = $400M x (1 - 0.25) = $300M

Invested Capital = $1,200M + $1,800M - $200M = $2,800M

ROIC = $300M / $2,800M = 10.7%

Why ROIC Beats ROE for Capital-Intensive Businesses

Consider a utility company with $10B in assets, funded by $6B debt and $4B equity. If it earns $800M in net income:

• ROE = $800M / $4,000M = 20% (looks great)
• NOPAT = $1,200M (pre-interest operating earnings after tax)
• ROIC = $1,200M / $10,000M = 12% (closer to reality)

The 20% ROE is inflated by leverage. The 12% ROIC reflects the actual return the business generates on all capital employed. The point is: for capital-intensive sectors (utilities, industrials, telecom), ROIC is the honest metric. ROE flatters leveraged balance sheets.

Sector Benchmarks (What Good Looks Like)

ROIC varies dramatically by industry economics:

Why this matters: A software company earning 15% ROIC may be average for its sector. A utility earning 8% ROIC may be excellent. Always compare ROIC to sector-specific cost of capital.

Economic Profit: The Real Value Creation Test

Economic profit (also called EVA or residual income) measures whether returns exceed the cost of capital:

Economic Profit = (ROIC - WACC) x Invested Capital

This is the only metric that answers: did the company create value this period, or just generate accounting profits while destroying capital?

Worked Example: Economic Profit

Tech Company:

• ROIC: 18%
• WACC: 10%
• Invested Capital: $5,000M

Economic Profit = (0.18 - 0.10) x $5,000M = $400M

This company created $400M in value above its cost of capital.

Industrial Company:

• ROIC: 9%
• WACC: 8%
• Invested Capital: $12,000M

Economic Profit = (0.09 - 0.08) x $12,000M = $120M

Despite having more invested capital, this company created less economic profit because its ROIC spread is thinner.

Struggling Retailer:

• ROIC: 6%
• WACC: 9%
• Invested Capital: $3,000M

Economic Profit = (0.06 - 0.09) x $3,000M = -$90M

This company destroyed $90M in value. It would have been better to return capital to shareholders.

The durable lesson: Positive accounting profits with negative economic profit mean the business earns less than its cost of capital. Growth in this scenario destroys value (more capital deployed at sub-cost returns).

Full Worked Example: Comparing Two Retailers

You are evaluating two retailers for a potential position.

Retailer A:

• Net Income: $450M
• Shareholders' Equity: $3,000M
• EBIT: $700M
• Tax Rate: 25%
• Total Debt: $1,500M
• Excess Cash: $500M
• WACC: 8%

Retailer B:

• Net Income: $380M
• Shareholders' Equity: $4,000M
• EBIT: $520M
• Tax Rate: 25%
• Total Debt: $600M
• Excess Cash: $100M
• WACC: 7%

Step 1: Calculate ROE

• Retailer A: $450M / $3,000M = 15.0%
• Retailer B: $380M / $4,000M = 9.5%

Retailer A looks better on ROE.

Step 2: Calculate ROIC

• Retailer A NOPAT: $700M x 0.75 = $525M

• Retailer A Invested Capital: $3,000M + $1,500M - $500M = $4,000M

• Retailer A ROIC: $525M / $4,000M = 13.1%

• Retailer B NOPAT: $520M x 0.75 = $390M

• Retailer B Invested Capital: $4,000M + $600M - $100M = $4,500M

• Retailer B ROIC: $390M / $4,500M = 8.7%

Retailer A still leads on ROIC.

Step 3: Calculate Economic Profit

• Retailer A: (0.131 - 0.08) x $4,000M = $204M
• Retailer B: (0.087 - 0.07) x $4,500M = $77M

Retailer A creates nearly 3x more economic value despite similar invested capital bases. The 15% vs 9.5% ROE comparison understated the difference; the economic profit calculation reveals it.

Common Mistakes (And How to Avoid Them)

Mistake 1: Screening only on ROE You filter for ROE >15% and load up on highly leveraged financials. When credit conditions tighten, these positions suffer disproportionately. The fix: always decompose ROE and flag equity multipliers above 3.0x (unless sector-appropriate like financials or utilities).

Mistake 2: Ignoring cost of capital You invest in a company earning 12% ROIC, thinking it is a quality business. But its WACC is 11%, meaning it barely covers its cost of capital. The fix: calculate ROIC spread (ROIC minus WACC) as your primary quality filter. Require at least +200 bps spread for conviction positions.

Mistake 3: Using book equity without adjustments Goodwill and intangibles from acquisitions inflate invested capital, depressing ROIC. A serial acquirer may show 8% ROIC when tangible ROIC is 15%. The fix: calculate both reported ROIC and tangible ROIC (excluding goodwill). The gap tells you how much return depends on acquisition accounting.

Next Steps

1. Calculate ROIC spread for your top five holdings. Pull EBIT, tax rate, debt, equity, and excess cash from the most recent 10-K. Compare ROIC to sector-appropriate WACC (use 8-10% as a default if unsure).

2. Run DuPont decomposition on any position with ROE above 20%. Flag positions where the equity multiplier exceeds 2.5x. These returns may not persist through a credit cycle.

3. Rank your watchlist by economic profit per dollar invested. The company creating the highest economic profit per capital dollar is generating the most value, regardless of size.

4. Set a sector-relative ROIC threshold for new positions. Require ROIC at least 200 bps above estimated WACC before initiating a position. This filter eliminates value-destroying businesses before detailed analysis.

5. Track ROIC trends over 5 years, not just current levels. Declining ROIC (even from high levels) often precedes multiple compression. Rising ROIC from a low base is a more reliable signal than a static high number.