Foolish Fundamentals: Return on Invested Capital

Return on invested capital, or ROIC, is one of the most fundamental financial metrics. But despite its importance, it does not receive the same kind of press coverage as do earnings per share (EPS), return on equity (ROE), and the price-to-earnings ratio (P/E) do. One reason it gets neglected is probably that you cannot obtain ROIC straight out of financial statements. Nevertheless, the concept is fundamental in measuring how much value a company creates.

So what exactly is ROIC? It is defined as the cash rate of return on capital that a company has invested. It is the true metric to measure the cash-on-cash yield of a company and how effectively it allocates capital. And that metric is:

ROIC = net operating profits after taxes / invested capital

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

For example, in its 2004 fiscal year, Motley Fool Hidden Gems pick Alderwoods Group (Nasdaq: AWGI  ) had a net income of $9.3 million. However, more than $6.9 million of that figure (after tax) came from interest and investment income. Obviously, Alderwoods' net income is not very representative of the profitability of its operations. Once adjusted to reflect operating activities, Alderwoods' NOPAT amounted to $47.7 million.

Fools do not invest in companies for their ability to generate investment income but, rather, for the profitability of their core operations.

The simplified formula to calculate NOPAT is as follows.

Start with:

+ Reported net income

Add back:

+ Goodwill amortization
+ Non-recurring costs
+ Interest expense

+ Tax paid on investment and interest income (effective tax rate * investment income)

Subtract:

- Investment and interest income
- Tax shield from interest expenses (effective tax rate * interest expense)

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 (interest-free).

Note that to calculate ROIC, we use the average invested capital for the period. For Alderwoods, invested capital for its fiscal 2004 was $1.4 billion.

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

The ROIC for Alderwoods is thus calculated to be 3.5%.

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 is expressed as a percentage.

So what does all of this mean for investors? For starters, Fools are better off tracking ROIC-WACC spreads than they are following EPS, net income, or ROE, since 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 does not indicate 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. There is thus a fundamental flaw inherent in using these traditional metrics.

ROIC can also be used to understand why stocks trade at different multiples, whether we are 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 is not only the level of ROIC that matters, but also the trend. A declining ROIC may be an advanced indicator signaling 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 is being more efficient at deploying capital. In all, ROIC is a valuable tool to assess the quality of a company.

Andrew Chan, Shruti Basavaraj, and Adrian Rush contributed to this article.


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