I just heard an analyst from a leading firm state one of his primary metrics is return on equity. Return on equity is important is important only as it provides a reflection of the firm's return on capital. For an obvious case, look at Apple (NASDAQ:AAPL), whose ROE pales compared to its ROIC as the firm is extremely adept at deploying cash as well as using other firms assets. In fact its equity is mostly cash.
If two firms have similar ROE, yet one has a higher ROIC, almost always go for the firm with the higher ROIC, as deploying cash into productive assets will yield higher free cash flows. Its cost of capital is also important, especially as it reflects its financial structure.
In today's investment marketplace, where many firms are overflowing with cash, the ability to redeploy cash having a low after-tax tax yield into projects and assets having a high return on capital will, in most cases be value-adding opportunities. If the firm is unaware of, shy regarding acquisitions, has a high cost of capital, or whose opportunities are currently producing low ROIC, deploying cash into new projects may be questionable. Mere accounting manipulation-such as an asset write-down-will improve ROE, as will a share buyback, yet both activities will not improve ROIC.
It is for this reason why investors and analysts should measure and prefer the cash on cash return in their acquisition analysis, to which ROE has a back seat. Income from cash is not included in the return on invested capital (ROIC) metric.
Example UPS (NYSE:UPS)
To calculate UPS's return on invested capital, I employ the definition espoused in Chapter 5 of my book Security Valuation and Risk Analysis, and the information contained in is 10K.
ROIC =Free cash flow - Net Interest Income/Invested Capital (Equity +Total Interest Bearing Debt +PV of Operating Leases-Cash +Marketable Securities).
UPS had produced normalized $2.9 billion in free cash flow from which we exclude its $100MM in net interest income as we are seeking its return on capital employed.
=2.9 -0.1/6.78+ 9.87 +1.1-1.05
=16.8% excluding loss in comprehensive income
=12.5% including loss on comprehensive income
Incorporating operating leases into the denominator lowers UPS's ROIC by about 6 percent. If the loss on comprehensive income (or part of it) were added back to shareholders' equity, the difference would have been meaningful. The company's ROIC is sufficiently above their weighted-average cost of capital (8.35 percent) to state that UPS most likely has many value-adding investments it could make.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.