Profitability Metrics

To evaluate profitability metrics correctly, you need a complete view of the three financial statements.

All metrics are NON-GAAP.

ROIC

Return on Invested Capital (ROIC) is a non-GAAP metric that measures a company’s ability to generate operating profit from the capital it has invested.

Charlie Munger, Warren Buffett’s partner, considers it one of the most effective.

ROIC is ideal for:

Assessing the trend and quality of non-financial businesses.
Comparing a company’s efficiency with its competitors or with its own historical results.

It tells us how much money the company is generating for every euro of capital it invests, considering only its productive activity. The average ROIC for the market typically ranges around 13–14%, but this value varies by sector.

However, a high ROIC on its own does not guarantee success. It is crucial that the company also has the ability to reinvest its Free Cash Flow (FCF) to fund its growth.

The formula to calculate ROIC is:

ROIC = \frac{EBIT \times (1-T)}{Invested\ Capital}

Where:

EBIT (Earnings Before Interest and Taxes): Operating profit.
T (Tax Rate): Tax rate. In the Balance Sheet section it is called: Effective tax rate.
Invested Capital: Sum of equity, total financial debt and operating leases.

Calculating Tax Rate

In case it is not reported or you cannot find it:

Tax\ Rate = \frac{Income\ before\ provision\ for\ income\ taxes}{Provision\ for\ income\ taxes} \times 100

Why this ROIC formula?

There are many ways to calculate ROIC. Why have we chosen this one?

Why do we use EBIT and not FCF?

EBIT (Earnings Before Interest and Taxes) is the metric we use to measure a company’s operating capacity, as it allows us to compare companies consistently.
FCF (Free Cash Flow) already has interest and taxes deducted. To make a fair comparison between companies, we would have to adjust FCF by adding interest back in, which would complicate the analysis.

Adjustments in the Invested Capital calculation

Why do we subtract “Marketable Securities”? This money is excess cash that the company does not need for its day-to-day operations. It could use it to pay dividends or buy back shares, benefiting shareholders. However, we never subtract this value in companies that have more debt than cash (Net debt).
Why do we add “Operating Leases”? Because these correspond to assets the company needs to generate or increase its EBIT. For example, the rent on a store or a fleet of trucks are essential operating expenses that should be considered part of the capital invested in the business.

According to Poor Charlie’s Almanack, in the long run, a share’s return rarely exceeds that of the underlying business.

This means that ROIC, although not ideal for comparing companies directly, is an excellent tool for predicting the results that can be obtained from a long-term investment, especially if the company has competitive advantages.

The ideal is for ROIC to be high and for the company to have the ability to reinvest its capital.

What really matters here is understanding that ROIC must remain stable over time for us to consider that a company has a competitive advantage.

If it swings wildly—30% one year, 5% the next—we should not consider that the company has competitive advantages.

Reinvestment rate

Although ROIC is important, it is essential that a company has the ability to reinvest capital in its own business. If it cannot, ROIC loses relevance.

What we need to analyze is whether the company is reinvesting a large part of the cash flow it generates. To do this, it is key to look at expansion CAPEX and M&A (mergers and acquisitions) items.

Some companies also reinvest from their OPEX. This makes the reinvestment rate calculation much more complicated and increases its margin of error.

The reinvestment rate can be calculated in the following ways:

Organic reinvestment rate

“Growth CAPEX” (expansion CAPEX) is estimated:

Growth\ CAPEX = Total\ CAPEX - D\&A

Inorganic reinvestment rate

It is calculated as Acquisitions amount / FCF.

Reinvestment\ rate = \frac{Acquisitions\ amount}{FCF}

Organic + inorganic reinvestment rate

Many companies combine organic and inorganic growth:

Reinvestment\ rate = \frac{Growth\ CAPEX + Acquisitions\ amount}{FCF} \times 100

There is no standard measure, but we need to look at the reinvestment rate and at ROIC. The higher the ROIC, the better.

ROE

Return on Equity (ROE) is one of the most widely used profitability and efficiency metrics for analyzing financial companies.

It measures the relationship between a company’s net profit and its equity. It is a non-GAAP metric when used for analysis, although it is derived from financial statements.

The average ROE for financial companies is typically between 10–15%. It is important to use this metric to compare companies in the same sector.

An important limitation of ROE is that it does not take into account the company’s debt, which can distort the picture of its financial health.

The formula is:

ROE = \frac{Net\ Income}{Equity} \times 100

Where:

Net Income: Net profit.
Equity: Shareholders’ equity, also known as book value.

ROA

Return on Assets (ROA) is also widely used to analyze financial companies. Unlike ROE, ROA does take into account the company’s debt, since it measures the relationship between net profit and total assets.

The average ROA in financial institutions is around 1%.

Above 1%: Considered an excellent sign.
Below 1%: Considered a sign of weakness.

The formula is:

ROA = \frac{Net\ Income}{Total\ Assets} \times 100

Where:

Net Income: Net profit.
Total Assets: Total assets, including current and non-current assets.

Cash Flow Valuation Multiples