What is return on invested capital?   

Most casual investors have probably never heard of the acronym ROIC.  Investors that do their homework before they buy a stock have probably run across ROIC, but don’t really understand what it is, or why it is important.  So, what is return on invested capital?  At a high level, ROIC is a way to measure how efficiently it uses the cash it invests in it’s operations – whether that cash comes from loans or cash it generates from its ongoing operations.  Another way looking at ROIC is the amount of profit that a business generates for every dollar invested in it’s ongoing operations.

Before we get into too much detail, here is how to calculate ROIC (return on invested capital):

Net Operating Profit After Tax
——————————————————
Invested Capital (Long Term Debt + Equity)

When trying to answer the question “what is return on invested capital?”, or “why is ROIC better than ROE?”, there are a couple of details that an investor must master.  First, unlike return on equity, return on invested capital looks at all funding sources that a company’s management team uses to fund the growth of the business.  This includes both equity investments from shareholders, as well as debt investments from bondholders and banks.  ROE only uses shareholder equity as the denominator in the equation, which leaves out long term interest bearing debt used to finance the growth of the company.

The other detail that an investor needs to get used to is not just looking at net profit, which is used in the ROE calculation that they are probably accustomed to seeing, but instead looking at net operating profit after taxes (NOPAT) instead.  The difference in these two numbers is that net profit includes income from all sources, whereas NOPAT looks at income from sales revenue.  Some of the income items that are not included with NOPAT are interest on investments (typically interest that accrues on cash and cash equivalents), revenue from sub-leased office space, etc.  In other words, NOPAT focuses on revenue generated only from the main focus of the business activities of the company you are looking at.

By focusing on after tax net operating profit, and ALL of the capital that a business is using to sustain and grow that cash flow, the time it takes to learn what is return on invested capital can give an investor a much better and deeper view on the health of a company that is being considered as an investment candidate.

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Return on invested capital (ROIC) is usually calculated with Net Operating Profit After Taxes (NOPAT) instead of just corporate profits more commonly measured as Net Income (NI).  What about NOPAT makes it a superior indicator of corporate profitability vs. net income?

NOPAT Definition

NOPAT (Net Operating Profit After Taxes) is the profit that a company realizes from ongoing profit generating operations of the company.  For example, a stereo store will count earnings from selling stereos using NOPAT, but will not count income from leasing out extra space in it’s stereo store building as an office to another business, as that is not a part of it’s primary business activity.  This is different than net income, which counts all income a company generates, even if it is not generated from it’s primary business activity.

How to calculate NOPAT

Here is how to calculate NOPAT:

Net Sales – Operating Expenses = Operating Profit (Also known as EBIT or Profit from Operations)
EBIT – Taxes = NOPAT

A good thing about NOPAT is that it starts with net sales instead of net income, which eliminates income and expenses that are not associated with the main profit making operations of a company.  This eliminates items like interest expense and interest income. 

By focusing on profits (earnings) that are generated from the ongoing operations of a company, instead of the overall net income of a company, which contains GAAP related items that create financial noise, a clearer picture will emerge to help you find companies that are growing and may make good investments.

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Earnings Yield

Earnings yield can help value stocks investors in their quest to find good solid companies that are currently relatively cheap.  Using indicators like return on invested capital (learn how to calculate ROIC), can be helpful in finding a list solid companies, and once you’ve identified this list, earnings yield can help you determine if the company is cheap enough to buy right now, after all, that is what value stock investing is all about.  Earnings yield does this by dividing a company’s annual earnings per share (you can use a trailing 4 quarters view of EPS for this if you’d like) by the company’s current market price per share.  This number is expressed as a percentage, which makes it easy to compare with bond yields.

How to Calculate Earnings Yield

There are a couple of ways to calculate earnings yield.  Since you don’t find this number in a lot of free online stock screeners, I’ll cover both methods, and you can decide which one you want to use. 

The first way to calculate earnings yield is to take the inverse (1/x) of the P/E ratio.  Since P/E ratios can be found in most financial publications, web sites, and stock screening tools, it is very easy to find this number, and invert it on a calculator or in a spreadsheet, to give you the earnings yield.  This method is very simple to use, and gives you a quick view of how cheap (or expensive) a stock is.

The other way to calculate earnings yield is a little more involved, but gives you a better understanding of how a company is valued relative to it’s earnings.  This form of earnings yield was written about by Joel Greenblatt in his book, “The Little Book That Beats the Market”.  The earnings yield he created is useful in comparing companies with different tax rates and levels of debt.  Greenblatt’s earnings yield formula is:

Earnings yield = pre-tax operating profit (EBIT) / Enterprise Value

So, in this case, the numerator (EBIT) comes from the income statement, and the denominator (Enterprise Value) is calculated by adding the market value of all equity – both common and preferred – to the value of all interest bearing debt that the company owes.  The value of equity is just the shares outstanding multiplied by the price of the stock, and interest bearing debt can be found on the company’s balance sheet.

I like Greenblatt’s method of calculating earnings yield better than the more popular E/P method, since it gives a more accurate view of what is happening inside of a company, and also gives a more balanced view when comparing multiple companies to each other.

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Free cash flow (FCF) is the left over cash a company has after paying for it’s growth and ongoing operations.  Free cash flow growth is another one of our primary indicators used for value stock picking, as it helps us gauge the relative health of a company.  The good thing about free cash flow is that it accounts for outlays of both expenses as well as capital asset purchases. 

How to calculate free cash flow

Learning how to calculate free cash flow is simple, and you can make it even more powerful when you use it together with other powerful value stock picking metrics, once you learn how to calculate ROIC and equity growth.  Free cash flow is calculated by subtracting capital expenditures from operating cash flow:

Free Cash Flow = Operating Cash Flow – Capital Expenditures

Operating cash flow is Net Income + Amortization/Depreciation – Changes in Working Capital

So the full Free Cash Flow formula looks like this:

Net Income + Depreciation/Amortization – Changes in Working Capital – Capital Expenditures
= Free Cash Flow

You can find the numbers for calculating free cash flow on annual or quarterly earnings statements for any public company you are examining.  Net Income and Depraciation/Amortization are on the income statement, working capital and capital expenditures are on the Cash Flow Statement (or Statement of Cash Flows).

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Equity growth rate for any company is also known as the book value growth rate.  Equity is what is left over when liabilities are subtracted from assets on a company’s balance sheet.  Equity represents what is left over if a company is liquidated and ceases to exist.  The equity growth rate is the percentage that equity per outstanding share of stock (or book value per share) has grown over the last year.  Equity grows when a business accumulates surplus profits.  Think about it – many profitable businesses have to use their earnings to fund their growth, either by building new stores, replacing old or worn out capital equipment, etc.  Businesses that accumulate excess profits while still growing are special indeed!  We use equity growth rate to find these great businesses.

How to Calculate Equity Growth Rate

Learning how to calculate equity growth rate is a great companion for the other skill you learned for finding great investments when you learned how to calculate ROIC.  Equity growth rate is calculated by dividing this years book value per share by last years book value per share, the subtracting 1:

Equity Growth Rate = BVPS(today)/BVPS(last year) – 1

Equity growth rate is represented as a percentage.  Make sure you adjust for dividend distributions (if any) to get an accurate view of equity growth rate.

What to look for in equity growth rate

Consistent equity growth of greater than 10% over 5 to 10 years is what a great company should have.  If you see some anomallies in the historical equity growth rates, take the time to understand why those divergences from the trend occurred (both up or down divergences).  Value investing looks for companies with good equity growth rates that may be temporarily under priced.  Comparing the equity growth rate between companies in the same industry is a good way to rate which ones should be considered as an investment.

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Return on equity is a popular fundamental analysis technique to measure how efficiently a company uses it’s shareholders’ investment to produce eanings.  The formula to calculate Return On Equity (ROE) is straightforward:

Return on Equity (ROE) = Net Income / Shareholder equity

Obviously this is a much simpler formula than how to calculate ROIC (return on invested capital).  Some investors would answer the “What is Return On Equity?” question by stating that return on equity is an easy and readily available way to compare different companies profitability.  A company with a high return on equity is more likely to be capable of generating cash organically (internally). For the most part, the higher a company’s return on equity compared to its industry, the better.  You need to look at ROE relative to the industry the company your evaluating is in, because not all high ROE companies make good investments.  For example, companies that require little very little assets, like consultants, will have high ROE’s relative to capital intensive companies.

So, hopefully this helped you understand what is return on equity.

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First a little history – value stock investing was popularized by Benjamin Graham and David Dodd, and their 1934 book, Security Analysis, remains popular to this day – many bookstores still stock this one on their shelves.  Famous investors like Warren Buffet and Mario Gabelli have made fortunes using the value stock investing strategy to find under priced stocks to buy.

Value stock investors look for stocks with strong fundamental characteristics, such as business revenue growth, cash flow, earnings growth, book value, and cash flow.  All of these items, and more, are found on company’s quarterly and annual reports.  The key is finding stocks that sell at a bargain price vs. their underlying quality based on these fundamental metrics.  Value stock investors constantly seek out companies that are currently incorrectly valued (i.e. undervalued) by the stock market and therefore have the potential to increase in share price when the market corrects its error in valuation.  Some good value stocks pay higher dividend yields due to their lower price relative to the dividend that they pay (there are even monthly dividend stocks that fall inot this category).

Since value stocks are under priced, this means that they are out of favor with the market, which makes value stock investors contrarians by definition.  Buying value stocks can, at times, be tough psychologically, because in many cases, you are buying companies or industries that are receiving a lot of negative press.  Right now there are companies and industries that you can read about in the news, where nearly every article you read in the business press, or every story about them you watch on television, is very negative.  As I write this article in Spring, 2009, there is a recession in full swing, with banks, housing stocks, and REITs all being whacked the most by the business media.  These are the types of areas where value stock investors are prospecting for good companies with good fundamantal characteristics, that are having their stock prices dragged down with the rest of the companies in their industry.  A good tool for determining if a stock is undervalued is to look at it’s earnings yield.

With the tools, resources, and articles posted on this website, value stock investing will become another tool for you to use in your successful online investing activities.

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You may already be familiar with one of the cousins of ROIC – Return on Equity (ROE).  ROE, which divides net income by the average shareholder equity over the time period being examined, is also a good measure of a company’s financial performance, and a favorite stock value indicator among value investors.  Click here if you want to learn more about what is Return On Equity.  The downside of ROE is that it does not take into account certain balance sheet liabilities that are being used to power a company’s growth, thus ROE may overstate the company’s economic efficiency.  ROIC corrects this issue, which is why I like it better than ROE.

ROIC is a good way to measure the quality of earnings growth, and is calculated with Net Operating Profit After Taxes (NOPAT) to focus on that earnings quality.  Lets use an example:  Company ABC sells a popular line of widgets, and earned $20 million last year.  This year, they decide to expand, and take on $20 billion in debt to finance that growth.  They are successful, and their earning double to $40 million.  Investors focusing on earnings growth are ecstatic – the company doubled it’s yearly earnings.  ROIC investors, however, are probably running for the exits, because they see that while the company doubled it’s earnings, the debt the company took on to finance that earnings growth only yielded a 1% return ($20 million divided by $20 billion), which is a very inefficient use of dollars invested in the company.  ROIC, unlike ROE or earnings growth, will highlight that inefficient use of dollars.  Investors looking for value stocks should look for high returns on invested dollars, as represented by ROIC, in addition to other key fundamental measures like business revenue growth.

Next up we will look at how to calculate ROIC.

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Picking good value stocks will cause you to rely on a fundamental analysis of the company’s operating condition, as represented in its quarterly and annual reports.  Fundamental analysis is concerned with values found on balance sheets, income statements, and statements of cash flows.  Don’t let fundamental analysis scare you, the numbers needed for choosing good value stocks are freely available on the internet.  One really good website for getting fundamental data, including pertinent ratios for value investors, is msn.com.

Good value stock picking uses some of the important and popular fundamental analysis ratios shown below:

Return on Equity

Return on Equity is one of the most powerful value stock measures available – it compares a company’s profit to the total shareholder equity as represented on the company’s balance sheet.  This ratio shows how efficiently the company’s management is using the shareholders equity.  Always look for companies with above industry average return on equity.

Book Value per Share

Book value per share is calculated the ratio, which is calculated by subtracting a company’s total liabilities from its total assets and then dividing this book value by the total number of outstanding shares of stock. Deep value stocks trade at or below their book value.  One thing to keep in mind when looking at book value on major money websites is that book value can count intangible assets like goodwill, it’s usually best to remove intangible assets from the book value equation before calculating book value (also known as Tangible Book Value). Use equity growth rate calculated with BVPS to find good stocks to invest in.

Earnings per Share (EPS)

Earnings per share are calculated by dividing total profit after tax by total number of shares outstanding. EPS can be found on most major financial websites.  For value investors looking for deep value stocks, you would ideally like to find a stock that has a consistent historical earnings growth rate.  A value stock may have a currently low price not because of an earnings miss, but maybe just an analyst downgrade, unfavorable news report, etc.  The important things to look for are consistently growing earnings both from quarter to quarter, as well as compared to the year ago quarter.  Read our article on Net Operating Profit After Taxes (NOPAT) for an alternate way to calculate earnings.

Price to Earning (P/E) ratio

Price to Earnings ratio is just what it looks like – divide a stocks price per share by it’s earnings per share, and you have the P/E ratio.  This number is also known as the earnings multiple of a stock.  When looking for a good value stock, we need the price (P) to be relatively low compared to the earnings per share (E).  “Relatively low” means you need to compare the stock you are considering relative to other stocks in the same industry, with similar earnings and sales growth rates.

Dividend Yield

A stocks dividend yield is important to value investors.  There are many studies that show at least half of the long term return you can expect from the stock market comes from dividends.  Calculate the dividend yield by dividing the annual dividend payout by the price of the stock.  Since value stocks are out of favor and low priced, you would expect a higher percentage dividend yield on a value stock. One thing to watch for on high dividend yield stocks is the percentage of quarterly earnings it takes to cover the dividend payout.  Value stocks as a group have generally hit a rough patch, so their earnings may be temporarily low, however, you really want to make sure that if/when your stock returns to a more favorable earnings climate, it will need no more than half of its quarterly earnings to cover dividend payouts.

Good value stock picking relies on a host of other fundamental indicators, and we will explore more of those in upcoming articles.  Additionally, using stock market breadth to help determine when the market is right to invest in is also critical in making the right investment decisions.  It is a compination of finding the right stock, and buying it at the right price, that tilts the odds of a successful investment in your favor.

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