by elmads

Introduction

There are tenths to hundredths of metrics used in analysing not just businesses (equities) but also other assets. Metrics which can be overwhelming for both new and even advanced investors to understand, not to mention that not all metrics are even applicable for all businesses and industries.

It’s not just that, the metrics, approaches and strategies utilized to pin point what is a wonderful business also changes overtime. In Robert Hagstrom’s book titled “Investing: The Last Liberal Art”, he cited these historical changes in the markets.

“In a Santa Fe Institute paper titled ‘Market Force, Ecology, and Evolution by J. Doyne Farmer,’ Farmer has taken the important first step in outlining the behaviour of the stock market in biological terms. His analogy between a biological ecology of interacting species and a financial ecology of interacting strategies is summarized in the table shown here.

If we go back through the history of the stock market and seek to identify the trading strategies that dominated the landscape, I believe there have been five major strategies:

1. In the 1930s and 1940s, the discount-to-hard-book value strategy, first proposed by Benjamin Graham and David Dodd in their classic 1934 textbook Security Analysis, was dominant.
2. After World War II the second major strategy that dominated finance was the dividend model. As the memories of the 1929 market crash faded and prosperity returned, investors were increasingly attracted to stocks that paid high dividends, and lower-paying bonds lost favour. So popular was the dividend strategy that by the 1950s, the yield on dividend-paying stocks dropped below the yield of bonds—a historical first.
3. By the 1960s, a third strategy appeared. Investors exchanged stocks paying high dividends for companies that were expected to grow their earnings at a high rate.
4. By the 1980s, a fourth strategy took over. Warren Buffett stressed the need to focus on companies with high “owner-earnings” or Cash Flows.
5. Today we can see that cash Return on Invested Capital (ROIC) is emerging as the fifth new strategy.”

The 5 seems familiar isn’t it? because those 5 are investing strategies that are still applicable to this day.

1.) Deep Value Investing

2.) Dividend Investing

3.) Growth Investing

4.) Value Investing via Discounted Cash Flow Model

5.) Modern Value Investing (Finding Businesses that are Compounders of Value)

I have a written an article about this titled “The Popular Investing Strategies”

Return on Invested Capital (ROIC)

This metric focuses on how efficiently the management generate more money with their initial capital invested.

In an individual level, it asks the question. How much money can you make after a year if you’ve invested your money now? If you have $1,000 can you make 50% more money from that? or probably double it after a year?

I know this metric may seem the same with Return-on-Equity (ROE), but it isn’t. Return on Equity divides Net Income of a company to its Shareholder’s equity in a given Fiscal Year.

It measures the efficiency of the management to make money relative to the equity of the company, or basically it’s net worth. In an individual level, it’s our yearly Return-on-Net-Worth (RoNW).

The difference of ROIC from ROE lies in the factors used to compute it.

You see, ROE removes the debt in the equation. Debt should actually be included, “why?” because debt is still money, an additional capital that can be used to invest for the company’s business operations. Meaning when companies, or even individuals take on debt, they’ll receive cash from their creditors which can be used for further business investments for growth and expansion.

Therefore, return on invested capital takes into account all of its money have/had invested back to the business, regardless where it came from, either it be from their core business operating income, sales of an asset, or from taking on debt. As long as it is the money they have reinvested, that will be considered the “Invested Capital”.

Formula

Return on Equity = Net Income / Shareholder’s Equity

Return on Invested Capital = Operating Income * (1 – Tax Rate) / Invested Capital

• Invested Capital= Fixed Assets + Non Cash Working Capital (Current Assets – Current Liabilities – Cash)

You can see clearly the difference in the equation. Return on Invested Capital focuses on:

1.) Existing Investments generating the cashflow today

2.) Growth assets which is the expected value that will be created by future investments

3.) Borrowed money through Debt.

All of the returns generated by these three will be compared to the business’ Operating Income.

You might be wondering why use the Operating Income/EBIT (Earnings Before Interest & Tax) for the numerator instead of Net Income. I’ll let professor Aswath Damodaran explain why: “It has to consider earnings not just to equity investors (which is net income) but also to lenders in the form of interest payments. Thus, operating income, as a pre-debt measure of earnings, is used in the computation, and it is adjusted for taxes to arrive at an after-tax return on capital.”

What is then a good ROIC? the answer here depends in what type of industry the business operates. Just like with other metrics I’ve discussed before such as the Price-to-Earnings Ratio, Price-to-Book Ratio, and Return-On-Equity, all are dependent in the industry. It is better if you compare all ROIC of companies in the same industry to arrive in its average ROIC.

Nevertheless, if you insist to find which is a good ball park to look for in an ROIC, then it would be 15% and above. This means, a business can generate 15% for every investment they make to their company, and if the company continues this over a long period of time, then they could double their Operating Income every 5 years. That’s a feat that not all businesses cannot do.

NOTE: A sustainable, increasing and high ROIC are one of the things that can give us a hint if the business we’re looking into is a potential company that we can own.

Below are my other articles regarding relative valuations:

• Price to Earnings Ratio Part 1
• Price to Earnings Ratio Part 2
• Price to Book Ratio
• Price to Tangible Book Ratio
• Fundamental Analysis – Liquidity & Debt Metrics Part 1
• Fundamental Analysis – Liquidity & Debt Metrics Part 2

The Downside

Same as with other metrics, it’s based on the financial accounting of the company we are studying. We assume and trust that the accounting method used is honest and without fraud.

Also, ROIC does not specify which segment of the business has generated the best return in a given year, in percentage terms. We could only surmise based on the revenue breakdown of the company.

To Sum It Up

Return on Invested Capital, though is almost as important as Return on Equity, still is considered by some as the star metric to finding companies that can grow over a long period of time. Businesses who posses long-term historical ROIC are called as the “Compounders of Value”.

Management that can give high Return on Invested Capital for their business says a lot of things. Mainly the durable competitive advantage of the company (most especially if it has been delivering high ROICs for years), and a good management.

A business and its management possessing the Midas touch, as every capital (either through their earnings or debt financing) that they have invested back to their business, turns into large sums of money in the future. No wonder this is the considered 5th and prevailing strategy in the ever evolving equity investing landscape.

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.