Return on Invested Capital (ROIC) is a measurement of how efficiently a company is allocating its capital. To put it simply, if ROIC is above the firms cost of capital, its creating value. If ROIC is below the cost of capital, its destroying value.
Cost of Capital
What is the cost of capital? Its the rate of return a company must generate in order to create value. Also known as the opportunity cost of capital. Most commonly, WACC is used, but I’ve made a separate post where I argue not to worry about this figure.
If a company has a “guaranteed” method of making 10% return on investment through for example investing in indices, then the cost of capital is 10%. This means that if a project’s ROIC is above 10%, its valuable. If less, it destroys value.
Measuring ROIC
Financial literature states different ways of measuring ROIC, but we’re going to keep it simple. The calculation is as follows:
NET INCOME
_________________
(EQUITY + DEBT)
You’ll find the net income from the income statement. Equity and debt are found on the balance sheet. Don’t use “Total Liabilities” in the calculation, since not all liabilities are capital invested into the company. Debt is a form of financing, and has the potential to generate returns. This is why ROIC includes debt and equity.
Since net income is the bottom line, after tax and all other deductibles, you might want to alternatively use operating income in your calculation. This is because corporate tax rates may differ, and can be a variable number. Operating income is also known as EBIT (Earnings Before Interest and Tax).
You should prefer companies with a demonstrated history of ROIC above 10% throughout the years. Below this, and chances are that indexing is a better alternative. Consistently high ROIC numbers also suggest a firm has some form of competitive advantage.
ROIC and ROE – Closing Remarks
Return on Equity (ROE) is a number that is more available by googling than ROIC. This this is because the calculation is so simple: Net income / equity.
There is nothing wrong with knowing the ROE, but the figure does not take debt into consideration. A high ROE does not equal a good investment if the firm is dangerously levered. Thus ROIC gives a better picture of how well a firm allocates its capital.
Remember, you are the business owner, and the management works for YOU. You wan’t them to make intelligent capital allocation decisions. They are your employees, not the other way around.
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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