Return on Invested Capital: Declining ROIC

We've already discussed how return on invested capital lets investors see the cash-on-cash return of a business -- literally, the difference between the amount of cash you invest in the business, and the amount you get back. The more cash you can get per dollar of investment, the better the business generally is.

Whether the company is financed with equity (by selling stock) or debt, ROIC doesn't care. It helps you filter out any distortions caused by a company's accounting method, and clearly see how well the company is actually doing, and how efficiently it's being run.

A clearer view
You need to view operating performance independent of financing, because conventional accounting does not treat all financing costs equally. While interest, the cost of debt, is reflected on the income statement, the more intangible (but no less real) cost of the equity capital is not reflected at all.

When you buy stock, you expect to earn a return. If investors do not get the return they expect, they will sell the stock to new investors, who expect their own target returns. The consensus expectation of all investors who own the stock is the cost of equity capital. Just because it's not deducted from earnings, like debt is, doesn't make it any less real.

This is why ROIC is so powerful -- it looks at earnings power relative to how much capital is tied up in a business. The whole idea of earnings growth seems less important in isolation when you compare it to how much capital is being poured into a business. It's easy to grow earnings by pumping more money into a business, but it's a lot tougher to do so without affecting your current ROIC.

ROIC in action
Suppose Wallace's Widgets (Ticker: WIDGT) has been able to grow operating earnings by 20% per year for five years. If you purchase it at a P/E of 10, you might think you've scored a great deal, since its growth rate is much higher than the P/E.

However, while you're focusing on all that earnings growth, you might not realize that the company's ROIC is dropping like a stone. It's investing ever-increasing amounts into projects that earn ever-dwindling returns:

Year

After-Tax Operating Earnings

Year-End Invested Capital

ROIC

Operating Earnings Growth

0

$100

$500

20%

20%

1

$120

$700

17.1%

20%

2

$144

$1,180

12.2%

20%

3

$173

$1,756

9.8%

20%

4

$207

$2,447

8.5%

20%

5

$249

$3,277

7.6%

20%

Right off the bat, Wallace's Widgets invests $500 in core projects that produce a 20% return. In its first year, it invests another $200 in projects producing a 10% return. Every year afterward, it sinks money into an unlimited number of additional projects that all produce only a 5% return. Since its initial projects offer the highest rate of return, earnings look good at first. But to keep those earnings growing at the same rate, the company has to plow more and more cash into also-ran projects with far more meager returns.

At the end of the period, the company's operating income is up 150%. However, the company's invested capital has risen more than 550%. With the newest projects only earning 5%, no Fool would be happy to see management investing new money at such a low rate of return. That's probably why the stock only trades at 10 times earnings.

Wallace's Widgets hasn't built shareholder value, because it has invested in projects whose ROIC falls below the rate investors expect. Those poor decisions have forced it to increase the capital invested in the business more quickly than it's growing its revenue and earnings. It had to keep investing in receivables, inventory, building warehouses, and other capital assets such as presses and trucks to create the 20% earnings growth that shareholders demanded. But over the intervening years, the company has likely had to take on lines of credit, issue commercial paper, and issue long-term debt and preferred stock to finance that expansion, because internally generated funds just couldn't cover it.

Even though management has focused on earnings growth, its horrible returns on new capital invested in the business prompt smart investors -- "lead steers," as Bennett Stewart calls them in his book -- to look elsewhere.

These "lead steers" want a company that is beating its "cost of capital" -- investing new money into projects that have ROIC exceeding the expected returns shareholders demand. How do you compare ROIC to the cost of capital? We'll cover that next.

For more lessons on return on invested capital, follow the links at the bottom of our introductory article.


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