Editor's note: This column is not a rerun! Today we welcome Fool of Fools Matt Richey back to our editorial team. Great to have you writing for us again, Matt. We missed ya!
Hi, Fools. It's great to be back in this space after not having written to you since last May. I'm excited to re-join this forum where we all learn together how to be smarter shoppers of the world's best businesses. Today I'm picking up where Bill left off last week as we look at Return on Invested Capital (ROIC). ROIC is a fantastic indicator of business quality and momentum, albeit with some limitations, which Bill discussed last time. In a moment, we'll put this tool to work and see what it tells us about Starbucks (Nasdaq: SBUX).
To review, ROIC has been popularized as an investment metric because it attempts to measure the essence of what companies do: take a dollar, invest it, and later on reap a return of something greater than a dollar. By measuring how well companies perform this basic investment process, ROIC hard-wires us to the pulse of a business and thereby answers the question "If I invest one dollar in this company's operations (NOT the company's stock), how much will be generated in return?" For example, if a certain business has an ROIC of 20% that means for each dollar invested in operations (e.g., equipment, office space, employees, and supplies), you can expect an operating profit of 20 cents.
When you strip out all the accounting complexities and jargon, that's what ROIC is -- a basic measure of how much you'll get out of a business per each dollar you put in. Obviously though to actually run ROIC calculations, you need a bit more definitional detail. For a full explanation of ROIC's definition and all the theory behind it, I can't do better than the two articles Bill referred you to last week: Andrew Chan's "A Look at Return on Invested Capital" and Dale Wettlaufer's "A Look at ROIC."
Today, what I want to focus on is applying ROIC to Starbucks and then looking at what it tells us. Here's how the calculation works when I pull numbers from Starbucks' fiscal 2001 10-K (all figures in $ millions; using ending invested capital as of 9/30/01):
Net Operating Profit After Tax (NOPAT)
ROIC = --------------------------------------
Invested Capital (IC)
Where,
NOPAT = Earnings Before Inc. Taxes $288.9
+ Depr. & Amortization + 163.5
- Interest & Other Income - 10.8
+ Internet investment losses + 2.9
--------
= NOP 444.5
* (1 - Effective Tax Rate) * 0.627
--------
= NOPAT $278.7
IC = Total Assets $1,851.0
- Cash - 113.2
- ST Investments - 107.3
- LT Investments - 0.0
- Total Current Liabilities - 445.3
+ ST Debt + 0.7
--------
= Invested Capital $1,185.9
$ 278.7
ROIC = ----------- = 0.235 = 23.5%
$1,185.9
If you slogged through all that with me, you're a true Fool! In the thick of all that accounting and arithmetic, please don't lose sight of the very simple meaning of this number: Last year, Starbucks earned an operating profit of 23.5 cents on each dollar invested in the business (new stores, coffee bean inventory, espresso machines, etc.). And this is actually a conservative estimate of the company's profitability considering that our calculation was based on end-of-year invested capital -- done for simplicity's sake -- rather than an average of the beginning and ending invested capital, which would've resulted in a higher ROIC based on a lower average level of invested capital.
An ROIC of 23.5% is an excellent level of profitability, more than double the historical 11% equity return of the S&P 500, and more than quadruple the risk-free 5.3% yield available on a 10-year Treasury. Any ROIC above 11% is decent, and anything above 20% is outstanding.
What else does a 23.5% ROIC tell us about Starbucks? It tells us Starbucks has a strong competitive advantage (something we all know, but which this number strongly confirms). Given the competitive forces in our free-market economy, no company generates an ROIC above 11% without some sort of competitive advantage. And if a company can demonstrate a high ROIC for many years, that implies a competitive advantage that may be sustainable for many more years into the future. This is the essence of Rule Making -- having such a strong competitive edge that the company is able to earn high returns on invested capital for years, decades, or hopefully longer.
Not only are we looking for high ROICs, but also ROICs that are either staying relatively level or trending upwards. Last week, Starbucks chairman Howard Schultz told Reuters, "We are opening three to four stores a day. I think the best is yet to come for shareholder value." A bold prediction in light of Starbucks' already-installed base of more than 5,000 stores, including over 1,000 locations outside the United States. As Starbucks continues to grow rapidly, investors will be well served to watch the trend of ROIC to see if Starbucks' future investments continue to prove as profitable as those of the past. If ROIC begins to drop off, that'll be a sure sign that the company is running up against saturation. And yet if ROIC holds up, Schultz may have some serious Rule Maker bragging rights.
Either way, Fools should keep in mind that Starbucks is already trading at a rich 45x earnings, a valuation bolstered by a piping hot venti cup full of investor enthusiasm. That doesn't leave too much in the way of a margin of safety no matter how well Starbucks' business performs. As with so many Rule Makers, the key is to identify these great companies, then wait patiently for an opportunity to pick up shares should the market ever offer an attractive price.
Matt Richey knows where practically every Washington D.C.-area Starbucks is located. While not a shareholder of the company, he does his part on a daily basis to bolster Starbucks' ROIC. His favorite blends, in order, are Caf� Verona, Sumatra, and Arabian Mocha Java -- room for cream, please, hold the sugar. See Matt's personal profile for his stock holdings and contact information.
