“Strong free cash flow generation, a long runway of free cash flow growth, and the price we pay for it are all that matters to long-term investing success.” ~ Motley Fool

Return on invested capital (ROIC) is the most important financial metric because:

• An increase in ROIC always increases intrinsic business value, but revenue growth does not always increase intrinsic value. Revenue growth only increases the intrinsic value when ROIC exceeds the weighted average cost of capital (WACC).
• Companies with high ROIC outperform the stock market by a country mile.
• Companies with rising ROIC (and high incremental returns on invested capital) outperform the market even more!

While profit, gross margin, operating margin, and revenue are all important, they are still only pieces to the ultimate scores: free cash flow and return on invested capital.

Free cash flow can be calculated from an income statement and balance sheet. Below is the equation.

Free Cash Flow (FCF) =

Earnings Before Interest & Taxes (EBIT) x (1 – Tax Rate)
+ Depreciation and Amortization
– Changes in Working Capital (Growth in Assets – Growth in Liabilities)
– Capital Expenditures (Property, Plant, and Equipment)

This free cash flow is what we care most about because it can be used to reward shareowners by either (1) paying down debt (which reduces the claim that debtholders have on the business and strengthens the company’s financial position), (2) paying a dividend, or (3) buying back stock at attractive prices. Then, any leftover free cash that isn’t used to pay down debt, pay a dividend, or repurchase stock can sit on the balance sheet and be used later (i.e., large cash and net cash positions create optionality value).

Free cash flow margin measures a business’s true economic profitability and cash-generating power. It is simply the number of pennies of FCF a company generates for every dollar of sales.

Free cash flow yield is the inverse of the enterprise value-to-FCF multiple. Thinking in terms of yield allows investors to compare a stock’s FCF yield to the risk-free rate (the yield on the 10-year U.S. Treasury bond), to the yields of other stocks and bonds, and to the yields from investing in real estate (a real estate’s cap rate is calculated as annual net cash flow divided by the purchase price of the property).

FCF yield is the amount of cash (as a percentage of the firm value) a sole owner could take out of the business every year to pay themselves. This is the excess, unencumbered free cash that is left over after investing to maintain and grow the business, and it is calculated as NOPAT less new invested capital, where invested capital is any form of investment including working capital, capital expenditures (property, plant and equipment), or acquisitions.

Return on Invested Capital is usually represented as a percentage or ratio and is calculated as follows:

Return on Invested Capital (ROIC) =

Earnings Before Interest & Taxes (EBIT) x (1 – Tax Rate)
÷ (Total Assets – Cash – Total Liabilities)

References:

1. https://www.stratechi.com/fcf-and-roic/
2. https://www.fool.com/investing/2022/06/29/companies-with-high-free-cash-flow-margins-and-hig/