Investors have a wealth of metrics and ratios -- among other tools -- to analyze companies on the stock market. Return on Invested Capital is a great way to assess a company's ability to generate value from the capital it invests in its business. The higher a company's ROIC, the stronger its pricing power and economic moat with the products and services it sells -- and the more value it can generate and return to shareholders.
Recently, General Motors (NYSE:GM) updated its executive management compensation. Now the company must exceed ROIC of 20% over a 3-year period for its executives to be rewarded by the incentive.
That's great news for investors, as it aligns management with shareholder interests. Let's take a look at how GM defines and calculates its ROIC, and what it means for investors going forward.
Return on Invested Capital
GM defines ROIC as EBIT-adjusted for the trailing four quarters divided by average net assets, which is considered to be the average equity balances adjusted for certain assets and liabilities throughout the period. Here's a look at GM's reconciliation of ROIC.
GM's goal is to achieve a 3-year average ROIC of 20% for years 2014, 2015, and 2016. There are multiple ways that GM can drive its ROIC higher, which is beneficial for investors as well as the company. Simple math shows that increasing your numerator or decreasing your denominator, or achieving both simultaneously, would result in a higher ROIC %.
The table below is a good example of how an increase in the EBIT-adjusted numerator will drive ROIC higher. In this case, 2014 shows GM's EBIT-adjusted figuring excluding recall costs, which took billions of earnings out of the automaker's wallet.
Also, if investors wish to take it a step further, a company's ROIC can be compared to its Weighted Average Cost of Capital (WACC) to see how much value the business is generating above the cost of the capital invested. According to Morningstar's calculations, GM's current WACC is 8.6%, and its ROIC didn't exceed the cost of capital until 2012.
What's the plan?
GM has a few strategies in place to make its business more efficient and thus improve the return on every invested dollar. The automaker plans to better prioritize projects and set specific product EBIT and ROIC targets, as well as country-specific ROIC targets. GM is also improving its annual business plan process to allow it to better identify upside drivers and downside risk. Individual reviews will also take place encouraging ROIC optimization and performance.
ROIC is a very important metric for any company, but it's especially important for investors to follow in capital intensive businesses like the automotive industry. It's a great metric for comparing profitability between two competitors within a given industry, and also provides insight as to whether a company has a valuable economic moat allowing it to generate higher ROIC over long periods of time.
Now that ROIC performance is tied into GM's executive compensation, investors should be optimistic about the company's overall direction in the years ahead. As GM's vehicle lineup continues to roll out with new designs, which drive higher earnings, and recall costs (hopefully) become a thing of the past, expect GM's ROIC to trend higher.
Daniel Miller owns shares of General Motors. The Motley Fool recommends General Motors. 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.