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 Intel
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 Intel, the big-dog U.S. microprocessor company, 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 Intel
|
2006 |
2007 |
2008 |
2009 |
LTM (through September 2010) |
|---|---|---|---|---|
|
10% |
13% |
14.1% |
12.7% |
20.9% |
What can we conclude? Intel's ROIC was actually 19.6% in 2005, so it's dipped down and then risen of late. As many of us know, corporate tech spending went through a down cycle a few years back and has rebounded of late as companies have both stockpiled cash and seen a need to upgrade. The key question is whether it will last, but at least for now, Intel is on the up and up – and the fact that it pays a dividend endears it to me (I'm the advisor of the Motley Fool Income Investor dividend service).
Direct competitor AMD -- just 1/24th as large as Intel by market cap -- is a poster child for knowing your financial statements. With an ROE of 5,773%, this company might appear to be a profit machine, but its more pedestrian 6.5% ROIC deflates that notion. AMD's 390% debt-to-equity ratio would seem to be the obvious culprit, but thank to heavy operating losses and goodwill writedowns a few years back, AMD's retained earnings balance is negative, which lowers its equity balance. In other words, it's arguably not quite as levered as appears. Meanwhile, graphics processor NVIDIA sported 16% returns a few years back but has gone negative in recent years thanks to sagging earnings. NVIDIA also has a substantial negative treasury stock balance, which lowers its equity figure. All this action casts networking giant Cisco in a plebeian light: Its ROIC has simply fallen from 16% a few years back to around 10% today. And finally, Idaho-based Micron Technology could be a Mauboussin come-from-behind candidate, with ROIC rising from 0.9% in 2006 to 9.2% most recently.
In the end, remember that ROIC is still a rearward looking measure. Intel -- or any of these other hardware outfits -- could be clobbered by a double-dip smackdown that depresses tech spending all over again. But out of the bunch, Intel's figures are among the most stable while still showing improvement.
Interested in Intel? Add it to your watchlist. Do the same for AMD, NVIDIA, Cisco, and Micron.
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