Return on Invested Capital

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Investors should give serious consideration to a company’s return on invested capital (ROIC) before they invest in a company by purchasing that company’s stock.

Investor educational company, Compounding Quality, provides the following example. Suppose that there are 2 companies:

  • Company A: ROIC of 5% and reinvests all its profits for 25 years
  • Company B: ROIC of 20% and reinvests all its profits for 25 years

Can you guess how much company A and B would be worth if you invested $10,000 in both (assumption: valuation remains constant)?

In this example, an investment in company A would be worth $33,860 while an investment in company B would increase to $953,960!

This simple example beautifully shows the importance of ROIC and the power of compounding.

ROIC is a measure of how much cash a company gets back for each dollar it invests in its business.

ROIC is a much better predictor of company performance than either return on assets or return on equity. In ROA and ROE, the key metric is net income. Net income often has nothing to do with the profitability of a company. Significant expenses are not included in net income such as interest income, discontinued operations, minority interest, etc. which can make a company look profitable when it is not.

Also, ROA measures how much net income a company generates for each dollar of assets on its balance sheet. The problem with using this metric is that companies can carry a lot of assets that have nothing to do with their operations, so ROA isn’t always an accurate measure of profitability.

Companies with higher-than-median ROIC (when viewed in conjunction with their overall capital-expenditure and operating-expenditure strategy) will deliver better returns over the long term. A high ROIC rewards companies that are able to produce the highest net operating profit with the least amount of invested capital.

What does ROIC mean?

Return on Invested Capital ratio provides insight into the extent to which a company efficiently allocates capital to profitable investments or projects, thereby generating returns. Comparing the ROIC to the weighted average cost of capital (WACC) reveals whether or not this is happening effectively.

ROIC basic formula

The basic formula for ROIC is as follows:

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ROIC uses net operating income after tax (NOPAT) in the numerator. This is obtained by reducing EBIT (“Earnings Before Interest and Tax”) by the prevailing tax rate.

For the denominator, this ratio uses invested capital. That equals total assets (current and fixed assets) minus non-interest-bearing current liabilities (all current liabilities excluding bank loans and leases).

  • Current assets = all items that are relatively easy to convert to cash such as inventories, trade receivables, cash investments and cash.
  • Fixed assets = all operating assets used by the company for a long time such as land and buildings which are considered tangible fixed assets. However, there are also intangible fixed assets to be taken into account, such as patents and goodwill.
  • Current liabilities = current liabilities with a maximum repayment period of one year such as, for example, supplier credit or taxes payable.

Relationship between ROIC and WACC

Revenue growth and return on invested capital are the basis of value creation. However, regardless of revenue growth, the return on invested capital must always exceed the cost of capital. Even high sales growth combined with too low a ROIC will always result in loss of value. After all, excessive costs eat into profits. So, reducing costs takes precedence over revenue growth.

The cost of capital includes the minimum expected weighted average return (WACC) of all investors for bearing the risk that the future cash flows of an investment may deviate from expectations.

Consequently, the ROIC result should always be compared against the WACC. Only when the ROIC is greater than the WACC can it be concluded that the company is earning more than the cost of capital and thus creating value. The formula to calculate the Weighted Average Cost of Capital is equal to the firm’s average cost of capital (cost of equity + cost of debt).

The basic ROIC formula includes by default all excess cash, goodwill and acquired intangible assets (patents, brands, etc.). If you use a minimum ROIC of say 15%, you will already be able to eliminate a lot of companies from your list. What remains are companies for which you know with certainty that they create value.

As an investor, you are searching for companies that are cash flow and earnings compounding machines. These companies have a high and consistent ROIC with plenty of reinvestment opportunities. This will allow the company to grow its free cash flow exponentially.

References

  1. https://qualitycompounding.substack.com/p/what-you-need-to-know-about-return
  2. https://www.chartmill.com/documentation/fundamental-analysis/indicators-and-ratios/416-Return-on-Invested-Capital-ROIC
  3. https://www.thestreet.com/opinion/10-stocks-with-high-return-on-invested-capital-and-why-you-should-care-13279076
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