Return on invested capital (ROIC) is probably the most important metric in value investing. After a quick analysis, it seems very obvious why ROIC is such a critical metric in assessing a company's prospects.
If I were judging an investment, and I could only ask three questions, I'd probably ask: What kind of returns can I conservatively expect? How much do I have to invest to get those returns? And for how long can I get those returns? In other words, I want to know my return on invested capital, and I want to know how long that ROIC will last.
Thus, earnings growth is a poor metric by which to judge a company. After all, if a company with $10 million in net income takes on $1 billion in debt and, after interest costs, earns an additional $10 million, that will increase earnings by 100%, but the ROIC on the additional investment will only be 1%. Clearly, this is not a great company, but an investor focused on earnings growth and not ROIC would miss this fact. Think of this like a basketball player who doubles his points-per-game average from 10 to 20. This sounds great, but if it takes him 30 shots to do it, then his field-goal percentage will plummet, and he's actually hurting his team.
How to calculate ROIC
Although the ROIC calculation is a little complicated, with some practice it actually starts to seem very simple. The formula is designed to compare all companies on an apples-to-apples basis. The first part of ROIC is the return. This is commonly calculated as after-tax operating income. Operating income, or operating revenue minus operating expense, is the purest form of judging a business's results. Operating income strips out non-recurring items and interest costs, which (excluding those of financial-service firms) don't have much to do with the actual business itself. The formula for the return is:
(1 - tax rate) * (earnings before interest and taxes)
Invested capital (IC), as you would imagine, measures how much capital a company has invested in its business. Although there are many different ways of measuring IC, in general, I calculate this as:
(total assets - cash) - (non-interest bearing current liabilities)
Basically, this equation says that the capital invested is the sum of all the assets, and subtracts out the assets that haven't yet been invested (cash and cash equivalents). Non-interest-bearing current liabilities are also subtracted out because they represent "interest-free" loans. For example, if I own a clothing store and a supplier extends me credit to buy and sell his apparel, I didn't have to expend any capital to get the use of the assets (the clothes), so this doesn't go into the IC equation. What we're left with is the total invested capital.
So simply dividing these two parts leaves you with:
ROIC = ((1 - t)(EBIT)) / ((A - cash) - (non-interest-bearing current liabilities))
Again, this is the after-tax return the business earns on its capital. If I apply this formula to Costco (Nasdaq: COST ) , Target (NYSE: TGT ) , and Wal-Mart (NYSE: WMT ) , all of which have been stellar stocks over the years, I calculate the ROIC of each for the last fiscal year as 14.5%, 11.5%, and 13.5% respectively. (Target's ROIC would probably be more in line with the others if not for its credit card business.) These ROICs, which are better than the average cost of capital, indicate that these firms are creating shareholder value.
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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. Costco is a Stock Advisor recommendation and Wal-Mart is an Inside Value selection. The Motley Fool has a disclosure policy.