ROIC, or Return On Invested Capital, is one of my favorite value investing indicators for trying to forecast the financial performance of a company’s stock. If you think about earnings growth at a high level, most companies have to pay a price to achieve earnings growth – by issuing stock, selling long term bonds (debt), investing in assets, and/or investing in working capital. ROIC is a superior way to measure this cost to achieve growth, and to compare one company’s financial performance to another company’s, or for that matter, to the performance of an industry group as a whole. In a nutshell, ROIC is a way of determining the amount of cash earnings a company produces for every dollar invested, and is a primary tool for value investing, along with equity growth rate, earnings yield, and free cash flow growth.
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.