Foolish Fundamentals: Return on Invested Capital

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Return on invested capital, or ROIC, is one of the most fundamental financial metrics. But despite its importance, it doesn't get the same kind of press coverage as earnings per share (EPS), return on equity (ROE), and the price-to-earnings ratio (P/E). In part, it's neglected because you can't calculate ROIC immediately from financial statements. Nevertheless, the concept is fundamental in measuring how much value a company creates.

ROIC is defined as the cash rate of return on capital that a company has invested. It's the true metric to measure the cash-on-cash yield of a company, and how effectively it allocates capital. Here's how ROIC breaks down:

ROIC = net operating profits after taxes / invested capital

NOPAT up top ...
Net operating profits after taxes (NOPAT), the numerator, is perhaps the best metric to measure the cash that operating activities generate. It's a better metric than net income, because it excludes non-operating items such as investment income, goodwill amortization, and interest expense. NOPAT's focus on operations makes it a better measure than EPS.

For example, in its 2006 fiscal year, Motley Fool Hidden Gems selection Middleby (Nasdaq: MIDD  ) had net income of $42.4 million. Of course, Middleby's net income doesn't fully represent its profitability. Once adjusted to reflect operating activities, Middleby's NOPAT amounted to $46.7 million.

For the most part, Fools don't invest in companies for their ability to generate investment income, but for the profitability of their core operations.

The simplified formula to calculate NOPAT is:

NOPAT = operating income [earnings before interest and taxes] x (1 - statutory tax rate)

... Invested capital below
Invested capital, the denominator, represents all of the cash that debtholders and shareholders have invested in the company. Invested capital can be calculated by subtracting cash and equivalents and non-interest-bearing current liabilities (NIBCLs) from total assets. Cash is subtracted because it does not yet represent operating assets. NIBCLs -- which include accounts payable, income tax payable, accrued liabilities, and others -- are subtracted from capital because they bear absolutely no cost (they're interest-free).

Note that to calculate ROIC, we use the average invested capital for the period. For Middleby, invested capital for its fiscal 2006 was $185.9 million.

So here's how to calculate invested capital.

Start with:

  • Total assets

Subtract:

  • Cash, short-term investments, and long-term investments (excluding investments in strategic alliances)
  • NIBCLs

Let's do the math
With a NOPAT of $46.7 million, and an invested capital number of $185.9 million, Middleby's ROIC would be 25.1%.

You can measure this ROIC against the company's weighted average cost of capital (WACC). Without the WACC, ROIC is not very useful, since the WACC represents the minimum rate of return (adjusted for risk) that a company must earn to create value for shareholders and debtholders. When the ROIC is greater than the WACC, it means that the firm creates value; otherwise, it destroys value. The difference between the ROIC and WACC is called the ROIC-WACC spread, and it's expressed as a percentage.

So what does all this mean for investors? For starters, Fools are better off tracking ROIC-WACC spreads than they are following EPS, net income, or ROE. Studies have shown that stock prices are highly correlated to ROIC-WACC spreads. Value creation is the key, and simply looking at EPS or net income won't tell you whether a company creates value. Furthermore, high sales growth can be harmful when new capital is being invested in value-destroying projects, yet EPS, net income, and growth do not tell how much capital was required to generate those numbers. Thus, there's a fundamental flaw inherent in using these traditional metrics.

ROIC can also be used to understand why stocks trade at different multiples, whether we're talking about P/E, enterprise value/invested capital (EV/IC), or price-to-book value (P/B). The P/E ratio is not only a function of growth, but also of ROIC.

Generally speaking, companies with higher ROICs are more valuable. It is important for Fools to understand, however, that it's not only the level of ROIC that matters, but also the trend. A declining ROIC may signal that a company is having a hard time dealing with competition. On the other hand, an increasing ROIC may indicate that a company is outdistancing its competitors, or that it's more efficiently deploying capital. In all, ROIC is a valuable tool to assess the quality of a company.


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