OK my faithful friends, let's dive into Return on Invested Capital (ROIC) as it relates to Rule Makers. I am going to give fair warning here: We will NOT be using ROIC as a definitive check for a company's suitability as an investment. We will use it as another tool in the old toolbox to ensure that a company is actually generating money from its operations. If you do not feel comfortable with the assumptions you'll have to make for an ROIC calculation, I seriously doubt that you are going to be forever at an insurmountable disadvantage as an investor. I do hope that you give it a chance and fire up the trusty pocket calculator and try a few cracks at calculating ROIC, though.

For this article and next week's we'll be using some companion documents, because I don't want to reinvent the wheel when we're already blessed with a couple of all-weather radial tires and big gnarly chains here on the site. Be sure to read Andrew Chan's exceptional Fool on the Hill article "A Look at Return on Invested Capital." (Note: with the exception of regular contributor Whitney Tilson, Andrew is the only Fool community member ever to have an article run in the Fool on the Hill space. That's a signal of just how exceptional this particular piece is.) We also have Dale Wettlaufer's  (TMF Ralegh) "A Look at ROIC" series. Both should be considered the real construction work on this subject. I'm just going to apply some paint and hang a flag out front.

In this first installment I'm going to define ROIC, describe what it tells us about companies, and then explain a bit how I'd like for the Rule Maker to use it. Next week we're going to lay out some examples using companies that are or could be within the realm of Rule Makerdom.

So, what the heck is ROIC? Let's break it down to its component parts. "Return" I think is self-explanatory: what you get in return. "Invested Capital" is the other component. Invested capital is two things: the interest bearing debt that a company holds, as well as the retained equity. This differs from the straight Return on Equity calculation because we have to make a few adjustments to get rid of non-liability liabilities, such as "deferred income taxes" to come up with the true amount of capital invested in the company.

One raw way you can think of invested capital is "delayed dividends." If a company earns $100 million in free cash flow in one year, but chooses to only pay out $10 million of that to shareholders immediately, spending the other $90 million on growing the business, the actual delay of payment of those dividends has a cost to the shareholder. It's like this: I give you $1 today, and obviously it's worth a buck. I give you $1 five years from now, and that dollar is worth somewhat less in today's terms. If we take an annual discount rate of 6%, then a five-year-from-now dollar is worth about $0.73. The determination of a discount rate for this investment capital is the single most difficult (and fudge-prone) part of an ROIC calculation. With any company, what discount rate do you use?

The answer is that it sort of depends. Take a look at this statement from Dale Wettlaufer on the subject:

"However, even though the cost of equity does not show up on a company's income statement, it is not free. Investors expect a rate of return on equity that is in line with the S&P 500 and that also takes into account the specific risks of the company in question. In this case, we have a company that has an average debt-to-equity ratio of 109% in the year 7 and may also be operating in a slower-growth industry with poor economics to begin with. In that case, we would demand a rate of return on equity of about 1.2 times the S&P 500's historical return to compensate for the extra risk. That means that the equity being used by this business will cost it 13.2%. A lower return on equity will hurt the valuation of the company's equity and ultimately the multiple the market will pay for all the capital invested in the business as well as its earnings and cash flow."

The reality is that the cost of capital number is not exact. We're going to parse through some examples to show some common thinking next week. For now, just try to concentrate on the concept, less on the methodology.

The other problem with ROIC is that under accounting methods, to my mind, assets are grossly understated. What are assets according to accounting protocol? They are the buildings and equipment that Starbucks (Nasdaq: SBUX) owns, along with coffee, those cool little sleeve things that they put around cups, and so on. But is that all of the assets Starbucks has? How do you value its brand? How do you value its mindshare? How do you value the fact that a Starbucks customer can travel to Doha, Qatar, walk into the Starbucks there and say "grande 2% no-foam latte" and end up with the very beverage he is looking for? None of these things are represented on the asset sheet, and yet they may very well be more valuable than the buildings, the espresso machines, even the company's stocks of coffee.

Troubling, and the bad part is, there is no way around it. This is why I would express an ROIC's usefulness not as a number, but as a range of numbers. We'll use this as one of our examples next week.

My best to all of you, and Fool on!

Bill Mann, TMFOtter on the Fool Discussion boards

Bill Mann has no idea why. He owns none of the companies mentioned in this article. The Motley Fool has a disclosure policy.