Geoff Gannon September 25, 2011

Valuing Financial Companies: ROIC, ROE, or ROA?

Someone who reads my blog sent me this email:

All else being equal, which measure is preferred for financial firms such as banks: ROIC or ROE?  I am using ROIC for non-financial firms but I didn’t know if it gave a useful reading for financial firms or not.




ROIC is not useful.

For non-financial companies:

I know you like ROIC. But I think it’s too clever by half.

I use the pre-tax return on tangible invested assets.

In other words, I look at what a company earns and divide those earnings by the assets on its balance sheet excluding cash and intangibles.

For financial companies:

Normally you use return on assets. Then you multiply ROA by an appropriate leverage ratio.

Say Wells Fargo (WFC) has a long-term average ROA of 1.3%. If in the future you expect banks to be levered 10 to 1, you would multiply 1.3% times 10 to get a 13% ROE. If you expect normal leverage to be 12 to 1 – you’d multiply 1.3% times 12 to get a normal ROE of 15.6%.

And so on.

For a good discussion of financial companies, read Variant Perceptions.