Return on equity vs invested capital

Return on equity rises when a company borrows. This ratio repairs that, at the cost of the widest legitimate disagreement in this course about how a denominator is built.

Three denominators, one profit

Take after-tax operating profit of 90 on one balance sheet. The operating route removes cash, non-interest-bearing current liabilities and construction in progress, because none of that money is working, giving invested capital of 750 and a return of 12.0 percent. The financing route starts from equity plus debt, less cash, giving 850 and 10.6 percent. Capital employed, total assets less current liabilities, gives 1,100 and 8.2 percent. Each is a legitimate answer to a slightly different question, and the same company can appear on two screeners over two points apart with neither screener wrong. ValueScreener usually stores this figure on the capital-employed denominator, as supplied by the data vendor, and falls back to equity plus debt less cash when that figure is missing. The source trail beside each number names which one was used.

The operating and financing routes differ here only by the construction in progress the first one removes.

Why the numerator is operating profit, not net income

Interest is a payment to a lender already counted in the denominator. Subtracting it in the numerator, then counting the lender's money as capital, charges the business for the same thing twice. So the numerator is after-tax operating profit, and which tax rate is a further choice: the US statutory rate, the effective rate from the income statement, or cash tax actually paid can move the answer by more than a point on an unchanged denominator.

Where the market sits

The 8 to 12 percent band people carry in their heads is often called ordinary. Measured against the market as it actually filed on 2026-09-07, 12 percent sat above the 75th percentile, 11.23 percent, of the 2,821 companies in the cohort. Utilities' own quartiles ran a narrow 4.07 to 6.16 percent, what a rate-regulated return looks like measured; Technology ran -22.19 to 14.20 percent.

What breaks it: banks, and leases

For a bank, deposits are the raw material of the business and sit as liabilities. Removing them removes the business; leaving them in makes the denominator a loan book, not invested capital. That is why 584 companies are excluded as not applicable, by business model rather than sector label.

Separately, ASC 842 put operating leases on the balance sheet as a right-of-use asset for fiscal years beginning after 15 December 2018. A lease-heavy company's invested capital stepped up at adoption with no change in what it pays in rent, so a ten-year series crossing that year is two measurement bases, not one trend. The rent itself stays in operating expense, so the numerator does not rise to match.

A fourth denominator

Joel Greenblatt's definition, in The Little Book That Beats the Market, divides pre-tax operating profit (EBIT) by net working capital plus net fixed assets, excluding goodwill and cash entirely. It answers a narrower question: what a business earns on the tangible capital it must keep in the ground to operate. Read alongside return on equity, the pair separates two facts. If return on equity is high and this ratio is not, the gap is debt. If this ratio is high and return on equity is lower, the company is likely holding cash or goodwill.

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