Is This Pharma Company Worth Its Salt?http://www.fool.com/investing/general/2010/11/02/is-this-pharma-company-worth-its-salt.aspx James Early
November 2, 2010
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 Pfizer (NYSE: PFE ) , and discussing competitors Merck (NYSE: MRK ) , GlaxoSmithKline (NYSE: GSK ) , Roche (OTC: RHHBY.PK), and Novartis (NYSE: NVS ) .
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
Two investing secrets emerge from the nuances of Mauboussin's findings:
1. If you find a rising ROIC, you could have a winner.
2. While a high ROIC alone doesn't help, consistently high ROIC is a marker of outperformance.
Will our next contestant come on down?