Friday, Jun 21st 2019

Titan Learn: ROIC and How It Drives Stock Prices


TLDR: This is it - the one metric you should know about. It can be used to evaluate everything - from a local business idea, to a large-cap technology stock.

30-second summary

Return on Invested Capital (ROIC) is often referred to as the single most important metric in gauging a business's quality.

The Wall Street Journal once called it the "hottest metric in finance." Warren Buffett has referenced it as the defining trait of his "ideal business."

So what is it? Conceptually, you can think of it as profits divided by investments. Or in more formal accounting terms ROIC = NOPAT / Invested Capital.

While this may seem like a mouthful, the concept is actually very simple at its core. It shows is how much money a business makes (profits) for every dollar that it puts to work (invested capital).

A quick example

Imagine a friend offers you the opportunity to invest in a restaurant, saying it will earn $200,000 in revenue with $50,000 in annual profits. Would you do it? "It's a 25% profit!" Trick question. You need more information.

What's being left out of this calculation is any measure of the "dollars in" necessary to generate these "dollars out."

Or in other words, how much capital do you need to invest to get to generate this that $200,000 in revenue?

If it costs $1 million to buy and set up the restaurant's building, ovens, furniture, etc. then it wouldn't be a very compelling business. You're only making 5% ($50,000 profit on your $1 million investment) every year.

Looking only at profits is a classic mistake.

Your cheat sheet: What types of businesses have the best ROICs?

Generally speaking, businesses that don't require a lot of heavy investments to run tend to have higher ROICs. These are referred to by investors as "asset-light" businesses or businesses that demonstrate "low capital intensity."

Think: businesses that sell intellectual property (like software), or service-oriented businesses like consulting or advertising firms. You can run those types of businesses with nothing but some standard office equipment.

On the flip side, businesses that require a lot of investment to keep up and running tend to have lower ROICs.

Think: airlines and utilities companies. These types of businesses require a lots of large investments and upkeep in expensive machinery and equipment. As invested capital makes up the denominator of ROIC, it should be unsurprising that these businesses don't generate great ROICs.

Why ROIC drives stock prices

The reason why ROIC stands out versus other metrics is because it represents the most fundamental comparison in assessing any type of investment - whether it's a stock, a project, or an entire business: how do dollars in compare to dollars out?

In doing so, ROIC captures a business's underlying performance. It shows the rates of return a business is able to earn on the investments it makes. Over the long-run, that's what drives value, which is in turn what drives long-term returns in stocks.

While stock prices can be volatile and often deviate significantly from a business's underlying performance over short time horizons, over the long-term, a stock's average annualized returns tend to approach the underlying business's ROIC.

As such, it should be unsurprising that ROIC is a highly scrutinized metric for long-term oriented investors.

If ROIC is so important, why don't people talk about it more?

The reason why ROIC is less commonly referenced and used despite its importance is because the calculation involves a few additional steps, often requires some adjustments, and isn't provided in most standard financial databases.

Compared to other more straightforward metrics, ROIC involves a bit more art than science. That said, even a rough calculation of ROIC can be very informative. As an investor, you're a business owner. And as a business owner, understanding the return profile of your business should be one of your top priorities.

Appendix: The nitty gritty

So how do we like to calculate ROIC?

The numerator, NOPAT, represents after-tax profits. It's relatively straightforward to calculate: Operating Profits * (1 - Tax Rate)

The denominator, Invested Capital, represents all of the money that has been invested in the business.

This is a very simple concept, but for large corporations with complex balance sheets, it can be more complex to tally up than you'd imagine.

There are numerous ways of calculating it, but we think the most straightforward is Total Assets - Excess Cash - Non-Interest-Bearing Liabilities.

A mouthful, we know. But as always, don't hesitate to reach out if you have any questions.

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