Is This Telecom Company Worth Its Salt?

Return on invested capital is one of my very favorite metrics. In this article, I'll show how you can use it to find stocks to buy, stocks to watch, and stocks to avoid, starting with Verizon (NYSE: VZ  ) , and discussing competitors AT&T (NYSE: T  ) , Deutsche Telekom (Nasdaq OTC BB: DTEGY.PK), Sprint Nextel (NYSE: S  ) , and Comcast (Nasdaq: CMCSA  ) .

Beware ROE
You've probably heard of return on equity, a favorite of Warren Buffett. It measures net income (the "return") relative to the equity capital a business has raised and built. A higher ROE signals a more efficient business.

But ROE can be gamed. Because debt is cheaper than equity financing, a management team whose bonuses depend on ROE targets may be tempted to lever up, increasing risk, just to juice net income and ROE.

Return on invested capital -- which is like a return on debt and equity -- catches this. ("RODE" would have been a catchy acronym, no?) To find ROIC, simply divide a company's after-tax operating profit by the sum of its debt and equity. Because it includes debt, ROIC is harder to fudge than ROE. Studies also indicate that watching ROIC can improve your returns.

Why ROIC reigns supreme
Michael Mauboussin -- the chief smart dude at Legg Mason Capital Management -- divided stocks into quintiles by ROIC in 1997, then tracked them through 2006. The lowest 1997 quintile ended up performing worst, unsurprisingly. But the stocks with the highest starting ROIC didn't perform the best, with annual returns of less than 6%, mainly because they fell out of the top quintile along the way.

Two investing secrets emerge from the nuances of Mauboussin's findings:

  1. If you find a rising ROIC, you could have a winner. Companies that started 1997 in the lowest or second-lowest ROIC buckets, but finished 2006 in the highest or second-highest, delivered returns of 14% annually.
  2. While a high ROIC alone doesn't help, consistently high ROIC is a marker of outperformance. Companies that started in the No. 1 or No. 2 quintile in 1997, and remained there through 2006, delivered a whopping 11% annually.

Will our next contestant come on down?
Let's see how Verizon, a U.S. telecom titan, stacks up by this measurement. We'll be using numbers from Capital IQ (a division of Standard & Poor's). For most moderate-risk companies, I consider anything greater than 9% to be a decent ROIC; over 12% is even better. The higher the risk, the higher the ROIC you'll need to be content.

ROIC for Verizon

2006

2007

2008

2009

LTM (through Sept. 2010)

8.2%

9.1%

9.2%

8.8%

8.1%

What can we conclude? Verizon's ROIC has been amazingly steady – a darn good thing. And while it's on the low side, I'll cut Verizon some slack for being a lower-risk business. What you don't see off-camera is that ROE fell for Verizon from over 12% five years ago to 1.1% most recently, despite a near doubling of the company's debt-to-equity ratio. In this case, the demon is massive restructuring charges, which aren't included in the ROIC numerator.

For the competition, AT&T has brought its ROIC up from 4.9% in 2006 to 7.9% most recently, whereas Deutsche Telekom – which yields a whopping 7.8%, by the way – has grown its figure from 3.6% to 5.5%. One thing to note about Deutsche Telekom is that it has a significantly negative retained earnings balance, which lowers the book value of its equity, whereas AT&T's equity is similarly reduced by its negative treasury stock balance – a result of share buybacks. Sprint Nextel, meanwhile, is ROIC negative with rising debt. On the cable side, competitor Comcast has grown its number from 4.3% in 2006 to 6.7% most recently – a good trend, although it also sports a negative treasury stock balance.

In the end, remember that ROIC is still a rearward looking measure. As we all know, Verizon will presumably be offering iPhones in the near future. On the flip side, Verizon and its telecom peers are still beset with technological and regulatory uncertainty, and nobody knows what the future holds. That said, I like my FiOS (though dealing with Verizon to hook it up was a nightmare), and I don't see the need for Verizon's services going anywhere but up anytime soon.

Interested in Verizon? Add it to your watchlist. Do the same for AT&T, Deutsche Telekom, Sprint Nextel, and Comcast.

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James Early owns no stocks mentioned in this article. You can investigate his Motley Fool Income Investor newsletter free for 30 days. Chevron is an Income Investor recommendation.


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