In 1999, Barron's published an article titled "Amazon.bomb," which predicted the e-commerce company's impending demise. The author of the piece repeatedly cited Amazon's lack of profitability as an indication that the business was poorly run and highly overvalued.
Hindsight being 20/20, it's obvious Barron's got it wrong on the quality of Amazon's management team. And yet, 23 years later, we find ourselves in a similar environment, with skeptics making familiar claims about less profitable growth companies.
To be fair to the critics, stocks did become highly overvalued in the last couple of years. But history has shown us that you cannot rely on a single valuation metric like the price-to-earnings (P/E) ratio, to judge the quality of a company.
One less-utilized metric that gives investors a contextual view into the efficiency of a company's management team is known as return on invested capital (ROIC).
Image source: Getty Images.
What is ROIC?
ROIC is a measurement of how effectively the leadership team of a business generates a return on the capital it deploys. And it's one of the most important valuation tools for investors to understand.
As an early investor, I heard statements like "buy quality companies and let them compound" countless times. While that sounds simple, the definition of quality is broad and subjective, depending on who you're talking to.
That's why I like ROIC. It's not subjective; it's a quantitative measurement of how well a company is allocating its cash.
Calculating ROIC
Calculating ROIC is a little more involved than other metrics like the P/E ratio. But bear with me -- it's not that scary.
The formula for ROIC is:
Net operating income after taxes (NOPAT)/ invested capital (IC)
Before you can calculate ROIC, you'll first need to generate values for the numerator and the denominator.
NOPAT represents the earnings a company would make if it had zero debt. To calculate this, simply multiply the company's operating profit by 1 minus the tax rate.
The operating profit can be found on the income statement, and the tax rate can be easily derived by dividing the income before tax by the tax expense (both of which can also be found on the income statement). Here's the formula for NOPAT:
NOPAT = operating profit (1-tax rate)
From there, you will need to calculate the numerator in our ROIC formula – invested capital. To get this number, head over to the liabilities section of the balance sheet and add up the long-term (or noncurrent) and short-term (current) debt, which is known as total debt. Subtract the cash and cash equivalents from the total debt to arrive at net debt.
The last step in calculating invested capital is to add the total equity from the balance sheet to the net debt you just produced. And now you have your ROIC denominator. Here's the formula:
Invested capital = net debt + total equity
Now that you have both your numerator and denominator, simply divide NOPAT by invested capital and you'll arrive at the company's ROIC. ROIC varies by industry so its important to compare a company's return on capital to competitors in the same space. But generally speaking a ROIC that is above 20% is high, and rising ROIC indicates a business that's improving over time.
Real world example of ROIC
Here's an example using Apple's 2021 financials :
The NOPAT is calculated by multiplying the operating income, $109 billion, by 1 less the tax rate. Apple's tax rate is 13% or .13 so to calculate Apple's NOPAT we simply multiply $109 billion by 0.87 which equals $95 billion.
Next we need Apple's invested capital which is its net debt, $84 billion, + its total equity, $63 billion, which equals $147 billion.
Finally, to produce the current ROIC, simply divide Apple's NOPAT by its invested capital:
$95 billion (NOPAT) / $147 billion (invested capital) = 64% (ROIC)
That number by itself gives us insight into how incredibly efficient Apple was in 2021 at earning a return on the cash it invested into its business.
But if we extend the calculation several years back, we get further insight into how the company's ROIC has changed over time:
|
Year |
ROIC |
|---|---|
|
2017 |
21% |
|
2018 |
32% |
|
2019 |
37% |
|
2020 |
42% |
|
2021 |
64% |
Data source: Apple 10K.
Here we see that not only is Apple generating a very high ROIC as of 2021, but it's also been steadily growing its ROIC over the last five years.
There are various other methods for calculating ROIC that might produce slightly different percentages, but what's most important is to look at the trend of ROIC over time. You should be looking for companies that are becoming more efficient with their capital (i.e., increasing their ROIC year-over-year), not less.
An important tool to add to your repertoire
ROIC certainly doesn't replace other metrics and analysis, but it's a highly effective tool at determining the quality of the management team and the overall trajectory toward higher profitability.
Earnings growth alone tells investors nothing about how much capital the business had to sink into the company to achieve that growth rate. By looking at ROIC, we can see if a business is getting an increasingly better rate of return on its investments or if it's slowly burning more capital to maintain a high growth rate. The latter should be a big red flag for investors.
