One grossly over-looked factor in investing is Return on Invested Capital, or ROIC for short…Many stock traders have no idea what it is. It is doubtful your (or your parent’s) money manager knows what it is or uses it. It’s time to change that. In this article, we will dive more into return on invested capital, examine what it is, how you calculate it, and why it is so important.
The original article has been edited here for length (…) and clarity ([ ]) by munKNEE.com – A Site For Sore Eyes & Inquisitive Minds – to provide a fast & easy read.
In business, ROIC is everything. It is a measure of how efficiently a company employs its resources to generate profits or, more importantly, free cash flow.
What the Heck is ROIC?
Lets start with the most obvious question – what exactly does return on invested capital mean, and what does it tell us?
An analogy may be the most apt way to grasp it. Imagine you are an investor, shopping for a mutual fund in which to park your hard-earned savings. Since you are investing for the long term, you leaf through prospectuses looking over the 10-year average returns. Fund A has delivered 15% annual gains to its investors, while fund B has delivered just 5%. Clearly, your money would have grown faster by being in fund A. The fund manager there better allocated the dollars under her control to achieve wealth for her investors.
The concept is no different if you replace “mutual fund” with “business”. Management has to decide how to allocate their capital, including equity capital (earned through the issuance of shares to the public), debt capital (acquired through bond issuance or bank loans), and operating earnings (earned through operations). The decision has to be made –
- do I spend to grow sales organically, for example by spending on product development or new sales territories?
- do I pay to acquire new business lines?
- or, are growth opportunities limited and acquisitions overpriced enough that I should just sit on my cash or pay it back to shareholders?
These decisions are at the core of senior management, and the effectiveness of these decisions are reflected in the return on capital number. A business with a higher return on capital, like a mutual fund with a great manager, will deliver more wealth to its shareholders over the long term.
Some Simple ROIC Formulas
The concept of return on capital can be calculated in a variety of ways.
1) Perhaps the simplest is return on assets (ROA). The return on assets equation measures the profit earned on each dollar of raw assets (buildings, cash, equipment, inventory, and so forth). The calculation here is:
- Return on Assets = Net Income / Total Assets
- return on capital equation can also be calculated by substituting “free cash flow” for “net income”. In a lot of ways, this is even better. Net income involves a lot of wonky accounting assumptions like depreciation, tax allocations, stock-based compensation, intangible asset impairments, and so forth. Put simply, “net income” can be gamed. Free cash flow is not as easy to fudge… this is the cold, hard cash brought in (or burned) by the company during the reporting period. So, “Cash Return on Assets” would be: Cash Return on Assets = Free Cash Flow / Total Assets
2) Return on equity is the profit earned on each dollar of equity capital – in essence, each dollar you own of the company. This is a bit more meaningful because it takes a firm’s liabilities and debt into account and gives a better estimate of what net capital actually is. The calculation(s) here:
- Return on Equity = Net Income / Total Equity
- Cash Return on Equity = Free Cash Flow / Total Equity
There are problems with each of the above measures, however.
- Return on assets is a useful equation for comparing firms within the same industry; for example, comparing United Airlines (UAL) against Spirit Airlines (SAVE). However, it is usually not useful for comparing firms in different industries with different capital requirements, and it also does not take into account what assets are actually employed in generating profits and which are “extra”.
- Return on equity, on the other hand, is somewhat better as it does subtract out liabilities. However, it can present a skewed picture for firms with a lot of debt. For example, Hershey (HSY) has a return on equity that looks outstanding at 92%, until you realize that the company has a $3 billion debt load against just $915 million in shareholder equity!
A Better ROIC Formula
A truer return on invested capital formula solves these problems.
- It counts only assets and liabilities that are employed in generating operating earnings, and removes the rest.
- Non-operating costs and profits, such as interest and equity investments, are removed to get a more clear picture of the business itself.
- The equation for calculating traditional invested capital is:
- Return on Invested Capital (ROIC) = Operating Earnings (EBIT) / Invested Capital
- or Cash Return on Invested Capital (CROIC) = Free Cash Flow / Invested Capital
where: Invested Capital = Total Assets – Current Liabilities + Short Term Debt – MAX(0; Excess Cash) – Minority Interest
Speaking of wonky! Honestly though, it isn’t that bad. We’re basically taking a return on assets calculation and subtracting out:
- Current Liabilities, which is capital the company owes in the near term (1 year or less).
- Short Term Debt, which is essentially the same thing.
- “Excess Cash”, which is cash not needed to cover current liabilities. If a firm does not have any excess cash (e.g. it is negative), we just use zero.
- Minority Interest, which we don’t own as common shareholders.
We are left with an “invested capital” figure that best represents what capital the company has CURRENTLY employed in generating earnings and cash flow! Dividing earnings or cash flow results in a percentage that is about as close as we can get to determining how much of a return that capital is generating for shareholders.
Backing Up A Bit and Conclusion
I realize this article was a bit geeky and full of jargon. Some investors like that stuff, some don’t. For those that were curious about these figures, which are used in the Magic Recipe Spell and the Quality Growth Spell, this should give some useful background.
It isn’t necessary to fully understand the details of these calculations, though. The important thing is what they tell us.
- Good companies have business models that generate high returns on capital – or, at least, have the potential to generate high returns on capital.
- Poor companies with poor business models do not.
It’s really as simple as that!
Related Article From the munKNEE Vault:
The ROE can be useful when deciding which company in an industry is the better investment. Let me explain.