The Magic of ROIC

Tom Gardner recently asked me, "If you could use only one metric to analyze a company, what would it be?"

I started to answer before Tom finished the question, but stopped. That would have been rude. But for me, the answer was so easy, so obvious that I couldn't wait to scream it out: return on invested capital.

Although no metric should be used exclusively, ROIC is as close to the cat's meow as we're going to get. It brings together the income statement and the balance sheet, it's flexible, it lets analysts combine qualitative and quantitative measures, it removes unsightly stains, it makes julienne fries.

OK, I don't know about the stains, but I can guarantee great fries.

Discovering Atlantis
Many investors stick too close to the income statement, focusing on sales and earnings growth. But that's not enough -- not even close.

What if a company is growing sales and earnings at 30%, but doesn't earn decent returns on the capital it uses? Should we care about that? After all, important items on the income statement are growing, and the market tends to love growth, right? There is no question in my mind that we should care about more than just sales and earnings growth. It would be foolish (small f) not to. And here's an example to illustrate why.

Hansen Natural (NASDAQ:HANS), a company I have picked on in the past (and that has made me eat my words), has an amazing record, growing sales and earnings at greater than that 30% bogey from above. iRobot (NASDAQ:IRBT) has, too. Both are asset-light companies as they don't have much in the way of plant, property, and equipment. Hansen earns 59% returns on its invested capital. iRobot earns 1.8% on its invested capital, and that figure is falling. Hansen has been a far better investment because not only has it been able to grow, it has been able to use capital very well as it grew.

Down and touch your toes
While the lack of a rigid definition can be worrisome (ROIC is a non-GAAP measure), I think flexibility is an advantage with ROIC. Sure, the equation is simple and straightforward. We simply take returns and divide them by capital. The fun part is determining which returns and which capital.

There are all kinds of adjustments that can be made, and I'm not going to go through all of them here. If you're looking for more info, I highly recommend reading The Quest for Value by G. Bennett Stewart. It's totally Foolish.

One adjustment I like to make when comparing companies is to take operating leases, which are off balance sheet forms of financing, and capitalize them and then add back the imputed interest. This allows me to make a better comparison between a company that uses lots of operating leases and one that owns assets.

Retailers are a classic example. Some own their stores. Many lease them. Unless you make an adjustment, the one without all that capital on the balance sheet is going to look much better.

Let's say I want to check on the battle for home improvement supremacy between Lowe's (NYSE:LOW) and Home Depot (NYSE:HD). If I take the results straight out of Capital IQ, it's Home Depot by 1 percentage point at 18.2% versus 17.2% for Lowe's. If I make adjustments for excess cash, operating leases, and other things mentioned in The Quest for Value, then the gap is not quite as large and the level drops to 15.3% for Home Depot and 14.6% for Lowe's.

The best of both worlds
The most important thing that ROIC allows an analyst to do is think about how a company operates and quantify its competitive advantages. Let's face it, if a company has an advantage, it should be able to earn excess returns over its competitors, and it should be able to do it for some length of time.

We can't get that from traditional value measures like price-to-earnings (P/E) and price-to-book (P/B) ratios. They simply look at the price investors are willing to pay for earnings or the accounting value of equity. You cannot assess whether one company is better than another from those ratios. You can get an idea by understanding and comparing ROIC.

Here's an example. You've decided to look at Panera (NASDAQ:PNRA), a family favorite, and Chipotle (NYSE:CMG), a personal favorite, to see which one is a better casual restaurant. Looking at the two restaurants, Chipotle is generating higher ROIC as it opens more restaurants. It's attracting more customers, getting them through the lines faster, filling them with a great product, and charging them higher prices. I can't say the same for Panera. So which one seems to have a competitive advantage in the casual restaurant battle?

The Foolish bottom line
Fools, listen to me. Put ROIC at the top of your analytical toolbox and take advantage of its magic. It brings together so many quantitative and qualitative measurements to help Fools see just how well a company is performing. But here's the real kicker: From ROIC, we can judge the value of a business. That's because value is a function of how much capital a company can use and the difference between its returns and its cost of capital.

Is there anything this metric can't do? Oh yeah, remove unsightly stains.

Fries, anyone?

iRobot and Chipotle are Motley Fool Rule Breakers recommendations. Home Depot is a Motley Fool Inside Value selection. Chipotle (B shares) is also a Motley Fool Hidden Gems pick. All of these market-beating newsletters are available for a free 30-day trial.