Do you want to keep a better handle on your investments but don't have the time or inclination to pore over financial statements every quarter? In "The Incredible Lightness of Part-Time Investing," we introduced financial ratio investing as a means to gain confidence in monitoring your investments over the long term. We described each of the four basic areas of modern financial analysis as answering a "big picture" question:
- Liquidity: Does the company have sufficient cash or other means to meet short-term obligations?
- Profitability: Is the company profitable during the period in question?
- Solvency: Can the company meet its long-term debt obligations?
- Activity: Is the company efficiently managing its assets and other resources?
In this series, we're looking at financial ratios that address each area. Return on invested capital, or ROIC, tracks the financial returns generated from a company's invested capital. It's related to both profitability and activity. Unlike many other ratios, ROIC has no standardized formula by which to be calculated, but most of the calculations you will see on financial sites are slight variations on the following:
Net operating profit after taxes / invested capital
"Net operating profit after taxes" is simply after-tax net operating income, with interest expense (net of taxes) added back in. "Invested capital" is the total cash that both shareholders and holders of debt have invested in a company.
In a nutshell, ROIC is a measure that tracks the amount of cash generated by each dollar invested in a company, both internally and by long-term debt-holders.
Why ROIC is a killer metric
Companies with a high ROIC tend to be efficient at utilizing both assets and debt. This is important because it's often difficult to evaluate a company's debt: Are borrowed funds primarily being used to take advantage of opportunities to increase long-term earnings, or are they merely a bridging mechanism? For an example, let's look at the personal-care and household-goods titan Colgate-Palmolive (NYSE:CL). Colgate carries an appreciable amount of borrowing on its books: Total current and long-term debt of $5.6 billion is equal to roughly 41% of the company's total assets figure of $13.5 billion. Having considered this, let's glance at Colgate's recent ROIC, expressed over a period of time:
As a rule of thumb across industries, successful companies typically generate ROIC in excess of 10%. Well-run multinational consumer-goods companies can often achieve ROIC greater than 20%. Colgate-Palmolive's ROIC gives you some insight into why it has earned a reputation for consistent, attractive financial returns. But it also reveals that the company is making efficient use of its capital structure: The significant amount of debt Colgate carries is contributing to, rather than hampering, the company's overall profit.
Tracking ROIC can throw up a yellow flag on debt
Viewing the trend of a corporation's return on invested capital can also provide information about when a capital structure is changing -- again, this becomes important when understanding the use of debt in an organization. Soak in the following chart on Priceline.com (NASDAQ:BKNG) for a moment:
Trailing-12-month operating profits are obviously vigorous at this leading Internet retailer. Why is ROIC dropping? Going back to our equation above, if the numerator (adjusted operating profits) is increasing, something in the denominator (invested capital) must also be increasing for the total measure to decline.
Looking at Priceline's last few quarterly balance sheets, you can see that the company has issued a tremendous amount of convertible debt beginning in 2012: On June 30, 2013, the balance of long-term debt stood at $1.72 billion. One chunk of these issuances, an $875 million offering, was the largest convertible bond offering in the U.S. for the year at the time (March 2013).
Cash raised from the debt will enable Priceline to buy back its shares, which it believes to be undervalued. Because the interest on the debt is extremely low, management obviously felt comfortable initiating this transaction. Just checking in on Priceline's ROIC would have alerted an investor to the increasing debt burden. Tracking ROIC for further declines will help you determine if, in the future, this strategy turns out to be weaker than expected.
Watch out for false signals
Sometimes a reputable company's ROIC will seem unusually low, but this is not necessarily evidence of poor returns. For example, both Ford (NYSE:F) and General Electric (NYSE:GE) would appear to have dismal returns on invested capital:
What's going on here? Aren't both of these companies fairly profitable, well-run, market-leading concerns? All of that is true, but in addition, each company carries a large amount of debt on its books via a financing segment. Both Ford and GE lend to their customers to sell their products, and each carries debt in the billions separate from debt associated with ongoing operations. This larger debt burden artificially deflates the ROIC metric. You will sometimes run into unusually low ROIC numbers for successful industrial corporations; consider this a cue to check in if the company in question is financing its products to a significant degree.
Frequency: check in once a quarter
Using the dynamic ROIC metric on a quarterly basis (when corporate financials are updated) will provide you with a deeper understanding of how your investments are faring. Moreover, if you combine this metric with other ratios, you may find that a bird's-eye view can keep you comfortable with your ongoing holdings and alert you when it's time to delve into finer detail.
Fool contributor Asit Sharma has no position in any stocks mentioned. The Motley Fool recommends Ford and Priceline.com. The Motley Fool owns shares of Ford, General Electric Company, and Priceline.com. 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.