An Arrow From Tom's Quiver

Question: When is high growth devastating for a company?

Answer: When it comes at too high a price.

Motley Fool co-founder Tom Gardner has used a bag of tricks to bag exceptional returns for his Hidden Gems newsletter -- returns of 40.6% since inception, versus a 9.2% return investors in the S&P 500 would have earned. I'd like to share one such tool today.

You're at the bank getting a loan at, say, 8% interest. You're going to take that money and boldly invest it in the stock market. Quick question: What return had you better get to avoid going bankrupt in a hurry?

8%. Duh.

Wake up, investors!
The same thing is going on every day with every company in the stock market, yet legions of investors don't pay attention. Perhaps they should, at least according to some persuasive empirical evidence.

But let's back up: What exactly is going on? Companies are taking money they've received from capital providers -- "invested capital," and in this case money from providers of debt and equity financing -- and putting it to use in the business; in projects that they hope will provide adequate returns, or, really, returns that beat the required return, as that's the whole point.

If you're heard of ROE -- return on equity, which is simply net income divided by a company's shareholder's equity balance -- you're already more familiar with return on invested capital (ROIC) than you realize. ROIC takes the same theory, juggling some income statement numbers to give you an income stream available to both debt and equity holders. In other words, it's a return after taxes, yet before interest expense (the return to debt holders) and the subsequent net income (the shareholders' return).

ROIC is championed by, among others, Warren Buffett and a famous former Credit Suisse First Boston honcho named Michael Mauboussin. Mauboussin, in particular, lays out several excellent papers on the topic, two thoughts from which I'll detail below.

Analytical Trap No. 1: Dwelling on EPS growth
In abstraction, growth is good, and earnings growth gets more -- way, way more, but that's another story -- of its fair share of Wall Street coverage. But Mauboussin's analysis failed to show a statistically significant relationship between EPS growth and stock prices. In other words, there's a bigger monster lurking under the bed.

Analytical Trap No. 2: Focusing on ROE alone
We love ROE, and rightly so, but it's at the beck and call of a company's capital structure decisions. Loading up that capital structure with debt will boost ROE, but at the price of risk. What if things go bad and you can't pay the interest? And in theory, a company's operational picture could be getting bleaker and bleaker while, thanks to additional leverage, ROE stays happily the same. It's not immoral for a company to protect its shareholders like that, but, hey, as an investor, you'd like to see around the turn, wouldn't you?

Bust out some math now...
There are several ways to calculate ROIC. Andrew Chan shows one here. Dale Wettlaufer has his say here. A simple way is to use an after-tax operating income for the numerator. For the denominator -- the invested capital -- take assets, then subtract out anything that came "free," as in sans financing. Since no return is expected on that stuff, it's fair to take it out of the equation, effectively giving kudos to the company for swindling free booty. Where is this free booty? In theory, buried within the "assets" balance, but double-entry bookkeeping leaves corresponding entries in the form on non-interest-bearing (basically non-debt) current liabilities. Things like accounts payable and accrued expenses represent short-term, but continuously replaced, loans of assets, labor, or money to the company. Subtracting these little interest-free loans, if you will, rightfully lowers the invested capital balance, thus increasing the overall ROIC.

Let's get specific
While I was in the mood, I took the liberty of painstakingly (I did mention that ROIC calculations are a lot of work, right?) running some ROIC figures for a few companies. As an FYI, someone using a different variation of the formula may get slightly different results. And as a disclaimer, this is meant to be a first-cut analysis; a more thorough one would include company-tailored adjustments -- GE, for instance, is an intricate beast that may best be analyzed as a set of numerous businesses.

I also took a look at marginal ROIC, a more skittish (i.e., subject to volatility) yet arguably more important measure than regular ROIC, in that by comparing incremental capital added to incremental returns received, it shows an additional degree of velocity. A company may show strong growth but may have added a ton more capital to get that growth.

Notice the dearth of fledgling companies? As with P/E, ROIC doesn't do a good job of deciphering companies whose best days are well ahead of them. It assumes capital is used for projects with near-term results, and, as such, is best for companies that have largely gotten into gear.

Now it's time to pay up
What have I forgotten? Oh, that's right... something about costs. Things like ROE and ROIC are useful to the extent you have an idea what they should be exceeding -- in your bank loan example, it was the 8% interest rate.

ROE should exceed the cost of equity, a notably imprecise cost and a subject beloved of academic arcana. Google "cost of equity" to learn more, but the basic idea is that the riskier the company, the more shareholders expect in return for investing. Stockholders, not academics, make the ultimate decision by theoretically pricing different return expectations into different stocks (although academics measure the market's collective voice), but a working cost-of-equity range might be from 6% or 7% on the safe side to 16% or 17% for a risky stock.

Because it's given in specific interest rates, the cost of debt is simpler. Since debt is held and listed in different durations, the main computations entail guesstimating, from its mix of short-, medium-, and long-term debt rates, what a company's overall, average cost of debt would be to acquire and retain long-term, ongoing, debt financing. I'll spare you the specifics today, but note that debt financing is generally cheaper than equity financing, especially considering the tax-deductibility of interest expense.

Once you've estimated your debt and equity costs, you need to do two more things to get the overall, weighted average, cost of capital. First, "tax effect" the cost of debt by multiplying it by (1 - tax rate). This gives credit to interest for being tax deductible and makes sense given that your ROIC numerator (often called NOPAT, for net operating profit after taxes) is an after-tax number. Second, take your cost of equity and newly computed after-tax cost of debt and multiply each by the proportion of the market value of its respective component in the company's capital structure. So a company that's 50% debt, at a 5% after-tax cost, and 50% equity, at 10% estimated cost, has a weighted average cost of capital (WACC) of 7.5%. It couldn't be easier, right?

The whole raison d'etre of a company is to generate a return in excess of its cost of capital. Measuring such can give insight beyond the simpler analytical formulas and can spot operational difficulties before ROE can. And ROIC is less susceptible to the murkiness induced by capital structure rearranging than is ROE. It's time to make ROIC a part of your analytical toolbox.

Like the idea of ROIC but fear the complexity? Tom Gardner puts ROIC and many other tools to work for you in his Hidden Gems newsletter. And he's got the results to back it up: As you heard earlier, his Hidden Gems picks have outperformed the benchmark S&P 500 by 31.2 percentage points since the newsletter's July 2003 inception! Talk about return on capital. Better still, Tom is making Hidden Gems available for a free, no-obligation 30-day trial. All you have to do is clickright here. It could be the easiest investing you'll ever do.

James Early wants massive returns on capital but owns none of the stocks mentioned in this article. The Motley Fool has a disclosure policy.