ROIC Growth Formula

The ROIC growth formula relies on evaluating return on invested capital (also known as ROIC) as a way of looking at stocks that helps smart value investors find good stocks to buy.  First let’s look at what is return on invested capital  , then we’ll examine why companies with comparatively large values of this key performance indicator tend to outperform their competition over time (and make good value investment candidates).

The first step in the ROIC growth formula is understanding how to calculate ROIC   for the companies that you are thinking about investing in, so here is the formula:

(Net Operating Profit After Taxes) / (Invested Capital)

Now there are a couple of things that must be noted about this formula.  First, net operating profit after tax (NOPAT)is not the same thing as net income.  Net income counts money that a company receives from all sources, whereas NOPAT is derived from the sales that a business makes from the ongoing operations of its main business.  Some of the revenue that is not included in NOPAT are things like interest income from cash and cash equivalents (short term securities like T-Bills), and rent from real estate that the company may own, but sub-leases to other businesses because it is not currently needed by the company.  These types of revenue, that are not from sales of the companies main products and services, add noise to what we are seeking – a clear view of the company’s operating efficiency – so we take them out of the equation.  The second thing that we have to consider is that invested capital is not just equity (like what is used in return on equity   (ROE) calculations), but also includes long term debt that is used to grow and sustain the business.

The ROIC growth formula is fairly simple – calculate the return on invested capital for the companies in the industry group you are considering investing in, identify the company with the highest value of this indicator, then buy it when it gets to a good price.  By comparing the return on invested capital values of companies in the same industry, the one with the highest return is likely to either continue dominating the industry, or, if it is not already dominating its industry, should outperform the industry over time.  If you think about it, the company with the highest return on invested capital is yielding a higher percentage of profit for every dollar invested in the company - either by equity share holders or debt bond holders.  The competitive advantage that allows a company to earn these higher than industry average returns are usually due to a dominating position in the market place, which makes it possible for them to charge more for their product or service relative to their cost, which leaves other companies in the sector competing based on price discounting (and lower margins).  Over time, this sustained competitive advantage allows the company with higher returns on invested capital to grow faster than its competition, which drives its stock price higher.

Technorati Tags: Cash And Cash Equivalents, Efficiency, Industry Group, Interest Income, Key Performance Indicator, Leases, Net Income, Nopat, Ongoing Operations, Operating Profit, Return On Equity, Return On Invested Capital, Roe, Roic, Smart Value, Stocks, T Bills, Term Debt, Value Investment, Value Investors

How to Calculate Return on Invested Capital   (ROIC) – Why use NOPAT?

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.

Technorati Tags: Array, Business Activity, Corporate Profitability, Corporate Profits, Earnings, Ebit, Financial Noise, Interest Expense, Interest Income, Investments, Leasing, Net Income, Net Sales, Nopat, Ongoing Operations, Operating Expenses, Operating Profit, Return On Invested Capital, Return On Invested Capital Roic, Selling Books, Stereo Store, Stereos, Taxes

What is Return On Equity?

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 0, 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.

Technorati Tags: Array, Assets, Capital Investors, Different Companies, Equity Investors, Equity Return, Fundamental Analysis, Intensive Companies, Investments, Investors, Net Income, Profitability, Return On Equity, Return On Invested Capital, Roe, Shareholder Equity, Shareholders, What Is Return On Equity

Lets look at how to calculate ROIC (Return on Invested Capital).  I make no secret that ROIC is one of my favorite value stock investing tools.   Learning how to calculate ROIC is relatively easy, and will require you to look at a company’s financial reports to get the numbers you need to calculate ROIC.

The formula for how to calculate ROIC   is:

ROIC = ((Net Operating Profit – Income Tax) / (long term debt + equity))

 ROIC calculations look like they have a lot going on, but I’ll now show you how easy it is to get everything so you can calculate ROIC.

Lets use Walgreens in 2007 as an example of how to calculate ROIC, click here  for the data you’ll need to follow along with this ROIC example.

From the Income statement, the numerator in the ROIC calculation (Net Operating Profit - Taxes) is 2041.3, you can find this about half way down the page.

The next step to learn how to calculate ROIC is to determine the denominator, so we’ll look at the Balance Sheet tab on the above Walgreens data, and find equity is 11,104.3, and long term debt (+ other liabilities) is 1284.8, which means the ROIC denominator is 12389.1.

So ROIC is 2041.3/12389.1 = 15.5%

Now you know how to calculate ROIC  .

Technorati Tags: Array, Assets, Balance Sheet, Capital Return, Cash Investments, Current Liabilities, Debt Equity, Denominator, Excess Cash, Favorite Tools, Income Statement, Income Tax, Income Tax Expense, Investing Tools, Liabilities, Net Income, Net Term, Numerator, Operating Income, Operating Profit, Profits, Return On Invested Capital, Roic Calculation, Sheet Tab, Stock Investing, Tax Calculations, Tax Rate, Term Debt, Total Net, Value Investing, Value Stock, Walgreens