Return on Invested Capital : An Important Ratio
When it comes to picking the best stocks, there are dozens – perhaps even hundreds – of metrics an investor can use for analysis. Many novice traders simply use the price-to-earnings ratio (PE) to compare stocks for their portfolios whereas some consider ROE to be a prime decision-making tool. Others go a step further and determine the free cash flow to a firm in order to find out how much money the company is generating. However, no discussion of important investment metrics would be complete without mentioning the Return on Capital (ROC). Every good business has to generate high returns on capital consistently because it is the fundamental driver of valuation.
High ROC over a period of time is a good indicator of identifying businesses with competitive advantages. There are several variants one can use to calculate ROC. In all cases, the measurement looks to capture the level of profits of a company expressed as a percentage of invested assets or capital. However, one of the most effective ways is to calculate the Return on Invested Capital (ROIC). Despite being one of the most reliable performance metrics for spotting quality investments, ROIC doesn’t get the same level of interest as compared to popular metrics like PE or ROE. This is simply because investors cannot pull off this metric from a balance sheet like they can with other popular ratios.
It requires some degree of understanding and a little calculation. However, for those eager to find out the true value a company is generating, calculating ROIC can be well worth the effort:
ROIC = NOPAT / Invested Capital
where,
NOPAT = EBIT (1 – Tax Rate) and,
Invested Capital = Net Working Capital + Net PPE + Other Operating Assets – Excess Cash
To start off, the numerator in this ratio consists of net operating profits after tax or NOPAT, which is simply the operating earnings or EBIT adjusted for taxes. By considering NOPAT, we are in effect acting as if we pay taxes on the operating income, ignoring the tax shield of debt and interest expense as a whole. This is because we want to incorporate the income received from all the operations in the company for both the equity and the debt holders. For small companies that do not have debt on their books, NOPAT is the same as net income. However, for many large companies, there are many ‘below the line’ items like income from discontinued operations, minority interest or interest income, which do not reflect the profitability in core operating activities.
In the denominator, we use invested capital, for which we start with the net working capital by subtracting the current liabilities from the current assets. We then subtract the cash which is in excess on the books from the net working capital. The non-cash working capital is then added to the net fixed assets (Net PPE), also known as long-term or non-current assets. This is essentially the net operating capital invested in the company to run its day-to-day operations.
ROIC is a highly reliable and useful metric to consider when measuring investment quality. It is not readily available like other popular ratios, and it takes a bit of work, but once investors start figuring out ROIC, they can be better armed to pick out stocks with great value. One should keep in mind to not just look at the level of ROIC but also the ongoing trend as a whole. A falling ROIC for a considerable period may indicate that the management is not able to pick good investments and will have trouble coping up with its competitors. On the other hand, an ROIC that is rising continuously strongly indicates that the management is making effective capital allocation decisions and helping the company pull away from its competitors. Such stocks deserve to trade at a premium to their peers, even if their PE ratios seem high.