Return on invested capital is one of my very favorite metrics. In this article, I'll show how you can use it to find stocks to buy, stocks to watch, and stocks to avoid -- starting with ExxonMobil
Beware ROE
You've probably heard of return on equity, a favorite of Warren Buffett. It measures net income (the "return") relative to the equity capital a business has raised and built. A higher ROE signals a more efficient business.
But ROE can be gamed. Because debt is cheaper than equity financing, a management team whose bonuses depend on ROE targets may be tempted to lever up, increasing risk -- just to juice net income and ROE.
Return on invested capital -- which is like a return on debt and equity -- catches this. ("RODE" would have been a catchy acronym, no?) To find ROIC, simply divide a company's after-tax operating profit by the sum of its debt and equity. Because it includes debt, ROIC is harder to fudge than ROE. Studies also indicate that watching ROIC can improve your returns.
Why ROIC reigns supreme
Michael Mauboussin -- the chief smart dude at Legg Mason Capital Management -- divided stocks into quintiles by ROIC in 1997, then tracked them through 2006. The lowest 1997 quintile ended up performing worst, unsurprisingly. But the stocks with the highest starting ROIC didn't perform the best, with annual returns of less than 6%, mainly because they fell out of the top quintile along the way.
Two investing secrets emerge from the nuances of Mauboussin's findings:
1. If you find a rising ROIC, you could have a winner.
Companies that started 1997 in the lowest or second-lowest ROIC buckets, but finished 2006 in the highest or second-highest, delivered returns of 14% annually.
2. While a high ROIC alone doesn't help, consistently high ROIC is a marker of outperformance.
Companies that started in the No. 1 or No. 2 quintile in 1997, and remained there through 2006, delivered a whopping 11% annually.
Will our next contestant come on down?
Let's see how ExxonMobil, one of the world's largest oil companies, stacks up by this measurement. We'll be using numbers from Capital IQ (a division of Standard & Poor's). For most moderate-risk companies, I consider anything greater than 9% to be a decent ROIC; more than 12% is even better. The higher the risk, the higher the ROIC you'll need to be content.
ROIC for ExxonMobil
|
2006 |
2007 |
2008 |
2009 |
LTM (through September 2010) |
|---|---|---|---|---|
|
30.5% |
29% |
33% |
13.7% |
16.3% |
What can we conclude? While ExxonMobil's returns have felt the recession, they're still high enough to indicate a killer business.
What about Exxon's peers? In America, ConocoPhillips returned 18% in 2006 but has seen its ROIC dwindle to 7.6% most recently in the wake of rising days inventory outstanding and despite falling capital expenditures. Chevron's numbers range from 22% in 2006 to 13.8% most recently (disclosure: Chevron is a recommendation in my Income Investor newsletter; among other things, I like that it's less exposed to refining, which hasn't been as profitable lately), whereas Shell's have fallen from 19.5% to 8.1%. The much-maligned BP's ROIC has gone from 16.4% to a negative number, not surprisingly, but to BP's credit, its pre-disaster figures were among the most stable.
In the end, remember that ROIC is still a rearward-looking measure. If the world did indeed hit peak conventional oil production in 2006 as some pundits say, the future could entail both higher selling prices for oil -- good for ExxonMobil -- and higher production costs, as well as an increasingly political oil climate as sovereign producers seek to defend their oil. But on the whole, I wouldn't bet against oil companies.
Interested in ExxonMobil? Add it to your watchlist. Do the same for ConocoPhillips, Chevron, Royal Dutch Shell, and BP.
