As Value investors, we spend our time looking for good companies that sell at a discount to their fair market value. Defining a “good” company is the first step in this process. Factors such as a strong market position and capable management are hallmarks of a quality company but can be subjective and hard to measure. A company’s ability to earn consistent profits is also central to increasing shareholder returns. Fortunately, one measure, Return on Invested Capital or ROIC, is easy to calculate and one of the best measures of a company’s ability to grow profits.
ROIC is appealing because it is simple. To calculate it, you divide a company’s after-tax operating profit or how much they have earned by the amount that debt and equity investors have given them to manage. In essence, it tells an investor how efficiently a company has used the capital it has been given. ROIC has been used as a measurement tool for decades but it is gaining traction among activist investors and management alike today.
While I would never recommend relying on just one metric to make investment decisions, it turns out that buying the shares of companies with high ROICs can produce positive results (see chart below). While I suspect studies that cover longer time periods would produce similar results, the results of this particular study do not surprise me. The period under study (2003-2016), included the financial crisis, a period during which investors were particularly willing to pay up for higher quality companies and many lower quality companies struggled.
We use ROIC when evaluating individual investments but add a twist by comparing a company’s ROIC with its borrowing costs. A company able to earn a return above its cost of capital is building, not destroying, capital.
All the stocks in the S&P 500 earned an average ROIC just under 10% last year. The average firm also earned more than its cost of capital although approximately 9% of the S&P 500 firms earned less.
ROIC is not perfect. Companies can suffer from a low ROIC, for example, by making investments which take longer to pay-off. ROIC, by definition, is also backward looking. It tells you how companies have performed but it does not guarantee how they will perform in the future. Take a look at the chart above. Investors are now willing to pay a high multiple of earnings (i.e., P/E ratio) for many of the companies on the list with high ROICs such as Facebook, Johnson & Johnson and Google. But a history of generating strong profits has not always guaranteed positive stock returns. Apple which sports the highest ROIC of the group, sold-off last year on fears of slowing iPhone sales. Conversely, GE, whose profits have been held back by weak commodity markets and a strong dollar, saw its shares advance a respectable 13% last year.
The point here is that ROIC gives us a picture of a company’s historic ability to generate profits. Determining how sustainable those profits are and, importantly, how much you should pay for that profitability are equally important steps in the analytical process.