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It is back-to-school week in towns and cities all over the country as hordes of students return to the classroom. In that spirit, Industry Focus is offering its own series of classes that hone in on key investing principles. For this Consumer Goods episode, Motley Fool analysts Vincent Shen and Asit Sharma dust off the blackboard to discuss return on invested capital, or ROIC.

After introducing the concept and how it can be used to evaluate your investments, they turn to case studies for three popular companies: Buffalo Wild Wings (NASDAQ:BWLD), Whole Foods Market (NASDAQ:WFM), and Marriott International (NASDAQ:MAR) to demonstrate some of the different ways ROIC can play a role in your portfolio.

A full transcript follows the video.

This podcast was recorded on Sep. 6, 2016.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host Vincent Shen, and it is Tuesday, Sept. 6. I hope everyone was able to enjoy their long Labor Day weekend. On the phone with me today is Asit Sharma, our senior consumer retail specialist, calling in from Raleigh, North Carolina. Asit, I'm really happy to have you back, how are you?

Asit Sharma: I'm great, Vince, and I'm thrilled to be back, especially after a really relaxing long holiday weekend, doing something I love, which is chatting about consumer goods with you.

Shen: Asit, on my commute into Virginia to head to Fool headquarters today, I felt there was this energy and tension in the air, because it happens to be the first day of school for a lot of Northern Virginia. We're talking about, in this area, hundreds of thousands of kids hopping on buses, going to school for their first day. What about your home state of North Carolina? Is school in session?

Sharma: Yeah, school is back in session. Many kids went back to school last week. I have three boys, and my two oldest ones are in a charter school that actually started on Aug 10. So, I definitely have dipped into that energy. Our household has been geared up in back to school. And I'll tell you, there's something about sending kids back to school that makes me want to learn something new. I mean, this is a great topic for today. Let's, you and I and our listeners, go back to school.

Shen: Yes. With that lead in, we have the honor of introducing a special back-to-school themed week for Industry Focus. Our goal this week is to take some investing concepts, break them down together, and put them into context with some sector specific examples. Today, Asit -- I should call you Professor Sharma -- I'll give you the honor of introducing the first topic of the week. What are we discussing?

Sharma: Sure. Today, we're discussing return on invested capital. You probably hear this or see this referred to as ROIC, in articles of companies you follow on the web. I'll tell you, it can be a mystical-type concept, but today, we're going to break it down in a way that you can use when you invest in companies.

Shen: Absolutely. This is actually a metric that I learned a lot about when I was in school for finance and accounting. And I did not see it as often as I would have expected, looking back on it and knowing how important it is now, actually, during my time on Wall Street. But I think it's a really nice metric to pair with other common measures. People hear about P/E ratios, for example. But, overall, I think this is just another tool that investors should have when they're evaluating a stock. There are some really great examples with popular companies in the consumer retail sectors that we can put this into perspective for.

But, right off the bat, it's important for anybody who's not familiar with ROIC [to know]: What is it?

Sharma: ROIC is actually a profitability ratio. It measures how a company uses its own capital. I'm going to pause here, because Vince, you've been to school for finance, and I have too, but this concept of capital is actually sort of mysterious, so I would love if we take a moment here to talk about what capital is.

Capital is the money a company raises in its initial public offerings, any follow-on stock offerings, plus money that a company may borrow in issuing bonds, taking on other types of debt, plus any profits a company makes that it chooses to reinvest in its business.

Now, if you think about all these sources of money, once those get invested into assets, those assets are often referred to as invested capital. When you hear this idea of return on invested capital, you can think of a profitability type return on money that has been invested into capital, and assets, which make a business scope.

Shen: Absolutely. On air, it's a little bit more difficult for us to break down with ROIC the actual calculations, because frankly, there are quite a few different ways to approach it. I don't think we're going to get into the nitty-gritty so much. There are plenty of sources on the different approaches of how to calculate it. But, more on the application, and how it can come into play when you're evaluating a stock, is probably a better way for us to focus on it on air.

Sharma: Yeah. We'd like to grasp this concept at 30,000 feet, and really discuss today with our listeners how you can get an edge over other investors if you get the big picture of a company's profitability on these assets it's put to work.

Shen:
OK. We have this general idea of what ROIC is. I think the best way to really solidify your understanding is look at our first example, which I think is really interesting, because it involves an activist investor, a company that I've always been following -- and frankly I'm a fan of their product offering. That's Buffalo Wild Wings.

The stock is down about 20% in the past year. Investors have kind of been forced to acclimate themselves to a more modest quarterly report. Same-store sales, for example, have swung from very impressive growth previously to negative levels for the first two quarters of 2016. With that, this activist investor has been voicing its concerns publicly. Its biggest complaint, very coincidentally, has a lot to do with our back-to-school topic: return on invested capital.

Sharma: True. That activist investor is called Marcato Capital Management. They've got a 5.2% stake in Buffalo Wild Wings, which is a pretty big stake. So they can throw their weight around a little bit. They issued this letter in mid-August, with the obligatory accompanying slide deck, a hefty presentation that goes through so many things that in the hedge fund's opinion is wrong with the way management is running the business. But I've read through that presentation, and they're really zeroing in on the fact that they don't think Buffalo Wild Wings is using its capital efficiently. 

Let's back up here and look at the quick-service industry, or fast-casual industry -- related industries in general. One thing that is par for the course when you have a successful restaurant business is to start franchising your name and letting franchisees come and open up businesses. You can expand more quickly, it's very profitable, because they are putting in the capital to open the stores and you're not. One great example of that is Burger King. Many of our listeners are familiar with Burger King as an investment. That's nearly 100% franchised. But Buffalo Wild Wings is actually going the opposite way, against the grain and against the trend. They're actually buying back their own franchisees. And the hedge fund thinks this is a big mistake because, it points out, Buffalo Wild Wings is acquiring franchisees at about 50% above replacement cost.

When we think of what it costs a company to open its own restaurant versus running a franchise, which is extremely capital-light, versus going out into the market and buying back one of its restaurants -- if you were in that driver's seat, you would probably want to avoid option three. Because, Vince, if I approach you and say, "Hey, how is that franchise going with Buffalo Wild Wings?" And you say, "I'm making lots of money." If I then try to purchase your restaurant, you're going to ask top dollar. But this is exactly what Buffalo Wild Wings doing, and the shareholders are not happy.

Shen: Absolutely. Granted, I think there are a few exceptions here and there in the restaurant industry. It is a very strong trend with the franchising strategy. I spoke last week with Sarah Priestley about McDonald's, for example, and part of their turnaround efforts has been pushing more into the franchising side. But here, you bring up a really good example. If I'm an owner of one of these franchises, and the corporate headquarters comes to me, and I'm generating a ton of cash and I'm really happy with my sales, the performance of my location, I know that this is more of a strategic buy for you. So, like you mentioned, I can ask for top dollar. And it seems to me like Buffalo Wild Wings management is very willing to pay that, as well. And that's taken a negative toll on some of the company's results, specifically with their return on capital, and why Marcato Capital Management is weighing in with this very public airing of grievances.

Sharma:
There's two interesting points related to that. One is, as you mentioned, their return on invested capital has declined almost 5% from 22% to 17% over the last year. The second point, which is fascinating, is: Why would Buffalo Wild Wings be doing this? Why not just take capital and build restaurants at cost, and create these new revenue streams? Marcato points out that Buffalo Wild Wings' management is incentivized to grow revenue and profits without regards to cost of capital. So, when you buy that restaurant, you're buying its revenue, too, which you can then put on your books, and that creates a bonus in management's pocket. That's part of the reason why this hedge fund, and other investors, are fired up at the way Buffalo Wild Wings is using its capital.

Shen: Yes. That makes a lot of sense to me. I think a lot of things in investing, and life in general, it comes down to incentives like that, frankly. And there's a very clear one if you're compensating management based on these other metrics. I don't know. It's almost hard to blame them for pursuing that, and I'm sure they're happy with those bonuses, obviously.

Overall, what do you think about this strategy? Do you have concerns tied with Marcato in terms of this having a negative long-term impact for Buffalo Wild Wings? Or, do you think this is something that can work for them. The fact is, something I noticed is that, when it comes to, for example, their quarterly comparable-sales growth, their operated units tend to put up better numbers than their franchised units.

Sharma: Right. And that's the counter-argument that I'm sure Buffalo Wild Wings management will make, is that we can go in and take a restaurant that is not operating as efficiently and improve the margins. And I'm actually a fan of some balance. You mentioned McDonald's, they actually have a fairly sustainable ratio. Right now, 80% of units are franchised, and 20% of units the company owns. They have a good mix of learning how to operate their own units, and then making money on the franchise side. If Buffalo Wild Wings' model, which is about 50-50 now, if they sustain that and can improve things, yes, they'll show greater revenue, greater profits.

My only concern is that there's some opportunity costs there, when they're using 50% premium of their own dollars to buy this restaurant, you wonder if they couldn't be more profitable. Instead of trying to go out and reacquire franchises they think they can operate more efficiently, why not just build them and operate them yourself? Building is better than repurchasing at a premium. I think over the long run, I agree with you, it may not look that bad on the books, but I worry about some money that's left on the table the way they're doing it. And we'll see. It's a good dynamic conversation that going to evolve between Buffalo Wild Wings and its shareholders. Maybe they'll shift that balance. It's going to be an interesting year coming up, to watch this company that we both like.

Shen: Yes. On this one hand, we started off with this company where, I think they're getting dinged on poor management of this topic that we have for today, with return on invested capital.

Let's move on to another company. This time, we're talking about Whole Foods. I feel like they're kind of gearing up in the opposite direction. Again, a really strong brand. They have a market leading present within their niche: organic and natural foods. The stock price has also been hurt recently. It's actually nearly been halved since early 2015.

Admittedly, this weakness has been driven by some of its own success over the past decade, with a lot of larger competitors being attracted to the very strong growth that is expected and forecasted to continue among this organic/natural food segment. These bigger competitors are more than happy to appeal to consumers in this target market with better prices, more convenient since they have bigger store footprints and networks. So, Whole Foods, ultimately, their market share has been kind of squeezed. Their revenue growth is slowing. Margins are getting squeezed, too. But they're turning in another direction with their new strategy. I'm going to let you dive right into it from there, Asit.

Sharma: Awesome, that's a great overview of Whole Foods. And I'm sure listeners who are invested in this company are eager to know: When is the stock ever going to move? The truth of the matter is, the competition that the company is facing is coming from all sides: larger operators like Costco and Wal-Mart, smaller ones like The Fresh Market. It's a multiyear process to reorient how the company does business. Of course, they're going to stick with their flagship stores. They are extremely profitable. They'll keep growing those. But they've figured out that a smaller store with a lighter footprint might not be a bad idea.

Vince, have you had a chance to visit one of the new Whole Foods 365 stores, by any chance?

Shen: No, I have not. I think there's two of them now that are currently open, but unfortunately they're both on the West Coast, so I haven't seen them yet. Though I've been able to see a walk-through that one of our writers, Brian Orelli provided, it's up on Fool.com, it has a lot of great photos. But unfortunately, I haven't seen it in person.

Sharma: Right, same here. I'm eager to, and hopefully I'll get to one soon. But I want to point out, for listeners who are in the same situation, who have heard about the store but only read about it, most of the press coverage has been focused on the fact that these stores offer cheaper prices, and they're meant to compete with Trader Joe's. That's what I've seen most often in the financial press. 

But let's look at it from management perspective. This is a company that is actually incentivized to improve return on invested capital. Whole Foods has a return on invested capital of about 13%, which is really good if you're a grocery store business. Traditionally, in that industry, at the end of the day you have 1% to 2% profit margins, and you're happy. So, an ROIC of 13% is pretty darn good. These new stores have a footprint of about 30,000 square feet. The average Whole Foods flagship store footprint is 47,000 square feet. They have a streamlined design, and it costs them less to build it. They also have really advanced technology, including auto-replenishment of their inventory. So, they have advanced analytics that tell them when they need to hit those replenish points and bring more produce back in, packaged goods, etc. So some of the human labor, in that instance, is not necessary. 

But because the management team is incentivized to maintain a high ROIC, they started looking at their competition problem differently than they would have in a vacuum. After a lot of time -- and this is, I think, two years of comparable sales that have been slowing and slowing and finally went negative -- management decided, "Let's go ahead and approach the problem not from a price and competition standpoint but from a capital standpoint." You can see, if your bonus was also dependent on producing high ROIC, you might also come to the conclusion that a lighter footprint store, a smaller store, might be the answer, versus just opening up more and more of these gigantic 50,000 square-foot stores.

Shen: Yeah, absolutely. And the beauty with the whole idea, this concept of the 365 by Whole Foods, it kind of hits the key challenges they're being presented with from the competition. The in-house brand offers arguably more competitive pricing, lower pricing, than their flagship stores. Then, they have this smaller footprint. The small store basically allows them to open up in more locations, opening up the number of consumers that have access to one of their store locations in general. That convenience factor, and the price factor, are going to be really important for them.

Sharma: Agreed. If we've got just a minute on this topic, I'd love to make one more point on this relationship between the customer interaction and ROIC. That is, if you fast forward, let's say 10 to 15 years, and you're in management's shoes, you have customers, like you just described, who really take to this format for convenience and price. But you have to start upgrading the stores, because after 10 years, they start to look a little stale.

Well, the cost to replenish that look, to renovate the store, to rehab the stock is a lot less when you reduce the cost of capital to begin with, when you've made the store smaller, when you've gone for light or less expensive materials, than it is versus the traditional Whole Foods Market 50,000-square-foot store. This is the power of paying attention to return on invested capital, sort of evergreen profits for your company. There are economic costs to everything. If you're efficient today, you can be even more efficient down the road, and keep churning out a great economic profit.

Shen: That is an awesome point. I was thinking about this more so from the beginning, the fact that opening these new stores is going to be less capital intensive. But 10 years down the line, taking that long-term, more Foolish outlook -- I'm really glad you brought that up, because that is a really good point. Taking this perspective that management is focused on with ROIC, it pays dividends down the line, obviously.

On that note, for this last topic which I want to spend a little bit of time on before we have to wrap up here, is a company that, based on our conversation, seems to be a gold standard in regards to this metric, and has done really well. This is in the hospitality industry, specifically the hotel business, which I think is really well-suited to our discussion. Obviously, when you think of building a hotel, it's very capital intensive -- some companies will spend hundreds of millions, if not billions, of dollars renovating properties or building new ones. But it's not as simple as that. The company we're talking about is Marriott International.

Sharma: Correct. Marriott International is a brand that has its roots in the early 20th century. For those of us who of are a certain age, like myself, full disclosure here, mid-40s, I can remember when Holiday Inn was the brand you went to when you were on vacation. This was the early 1970s. But Marriott was the place you stayed in occasionally. It was a higher-end brand, and still is, and it's continued to polish its own brand and acquire other very respected brands in the hotel industry.

What it's done is it's transitioned from being an owner-operator of hotels to now primarily a franchisor that also manages properties. So, they also have some property management revenue. It has a stable of luxury brands, including Ritz-Carlton and very many limited-service brands which all of us are familiar with, including Courtyard and Residence Inn. I'd like to read a statement for our listeners which has to do with return on invested capital. This is from Marriott's CEO, Arne Sorenson. This was in the company's quarter two press release issued just a few weeks ago. Sorenson says, "Our business model remains focused on managing or franchising the finest hotel brands around the world. This asset-light strategy minimizes our exposure to economic cycles even as our brands grow their distribution."

Vince, I'll be quiet now and let you jump in, I just wanted to say that this sort of encapsulates everything we've discussed today, this approach to thinking about your assets and trying to get a greater and greater return on them.

Shen: Absolutely. I was really surprised as I was learning more about this company. It wasn't one I've followed as closely, but doing the research for the show, I was blown away to see that in their filings, the company operates over 1,000 properties, some 30,000 rooms, owns six of them. Then, its franchised properties, on top of that, amount to 3,000, another 420,000 or so rooms. But, you can see how the model has transitioned to where now, it's not as much owning it but making money from the royalties that they get from franchises, the management fees, the incentive fees. It's a really interesting example. I'll let you wrap it up, but I think it's really important to quantify it, how strong the results are that they've been able to put up with this metric for ROIC.

Sharma: Marriott is sort of quiet friend, isn't it? We know it's there, but many of us don't spend a lot of time looking at the stock. But the stock is up 150% in the last five years, and it's no coincidence that Marriott's ROIC has skyrocketed over the same period to 50%. That is an incredible return on invested capital. By employing this strategy, management understands that they have a smaller and smaller capital base, greater and greater revenue, that return will increase. Shareholders love it.

One last point to wrap up today's conversation -- we'll stick with Marriott -- it's important to trace how your assets may change over time. When you see you're developing intangible assets, like a really great brand, then it's time to consider whether you should still be investing in the hard assets like the hotels. And Marriott gets that. They want to license their name, and let other people take the capital and take the risk, and just collect those royalty checks. If you're familiar with the hospitality industry, you probably know the term "flag". It's what insiders use to describe the various properties. And Marriott has a really desirable flag because of their reservation system. If you're out building a new hotel at the edge of a very robust metropolitan area, you want to be on Marriott's system, because you're almost guaranteed enough occupancy to be profitable. So, management leverages that by saying, "Yeah, go ahead and build it, we'll let you have our trademark, send us a check every month and everyone will be happy."

Shen: Alright, thank you Asit. Really great takeaway at the end there. I really like the three companies we were able to talk about in trying to put this metric into context. Otherwise, thanks again for coming on the show, and I really look forward to having you on again soon.

Sharma: Same here. And listeners, we're out of time, we can't do the pop quiz, but be ready next time we do back to school. Thanks Vince, great to chat with you.

Shen: To continue on that wonderful theme, you can come to office hours via Twitter @MFIndustryFocus, or send us any questions or comments via email at IndustryFocus@fool.com. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentions, so don't buy or sell anything based solely on what you hear during the program. Thanks for listening and Fool on!

John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Vincent Shen has no position in any stocks mentioned. Asit Sharma has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Buffalo Wild Wings, Costco Wholesale, Marriott International, and Whole Foods Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.