April 20, 1999

A Look at ROIC

By Dale Wettlaufer (TMF Ralegh)

Return on invested capital (ROIC) is a measure of financial performance and a financial performance forecasting tool that the Fool analysts have used for more than a year. We believe that looking at economic earnings -- free cash flow or return on invested capital minus a charge for the use of that capital -- produces a much better view of the economics and value of a company than just looking at earnings growth. After all, earnings growth comes at a price in many instances -- whether that's heavy investment in working capital, fixed assets, or the issuance of stock to acquire other businesses.

This series is an introduction to how ROIC is calculated. We believe it's as fundamental as learning how to calculate EPS or calculating a company's current ratio. It's not profit margins that determine a company's desirability, it's how much cash can be produced by each dollar of cash that is invested in a company by either its shareholders or lenders. Measuring the real cash-on-cash return is what ROIC seeks to accomplish. Keep in mind that this series initially ran in July of 1998. Therefore, the financial data in some examples is from that time period.

We will be adding to this collection in the future and we will also improve the explanations as our ability to teach improves. The subject treatment here is somewhat simplified. For more advanced investors, we recommend The Quest for Value by G. Bennett Stewart III.

Next: Better than ROE