ROIC A Preferable Path To Measuring Profitability

ROIC is a highly reliable and useful metric to consider when measuring investment quality. It is not readily available like other popular ratios and it takes a bit of work, but once investors start figuring out ROIC, they can be better armed to pick out stocks with great value, suggests Anthony Fernandes

When it comes to picking the best stocks, there are dozens – perhaps even hundreds – of metrics an investor can use for analysis. Many novice traders simply use the price-to-earnings ratio (PE) to compare stocks for their portfolios whereas some consider ROE to be a prime decision-making tool. Others go a step further and determine the free cash flow to a firm in order to find out how much money the company is generating. However, no discussion of important investment metrics would be complete without mentioning the Return on Capital (ROC). Every good business has to generate high returns on capital consistently because it is the fundamental driver of valuation.

High ROC over a period of time is a good indicator of identifying businesses with competitive advantages. There are several variants one can use to calculate ROC. In all cases, the measurement looks to capture the level of profits of a company expressed as a percentage of invested assets or capital. However, one of the most effective ways is to calculate the Return on Invested Capital (ROIC). Despite being one of the most reliable performance metrics for spotting quality investments, ROIC doesn’t get the same level of interest as compared to popular metrics like PE or ROE. This is simply because investors cannot pull off this metric from a balancesheet like they can with other popular ratios.

It requires some degree of understanding and a little calculation. However, for those eager to find out the true value a company is generating, calculating ROIC can be well worth the effort: 

ROIC = NOPAT / Invested Capital
Where, NOPAT = EBIT (1 – Tax Rate)
And, Invested Capital = Net Working Capital + Net PPE + Other Operating Assets – Excess Cash.

To start off, the numerator in this ratio consists of net operating profits after tax or NOPAT, which is simply the operating earnings or EBIT adjusted for taxes. By considering NOPAT, we are in effect acting as if we pay taxes on the operating income, ignoring the tax shield of debt and interest expense as a whole. This is because we want to incorporate the income received from all the operations in the company for both the equity and the debt holders. For small companies that do not have debt on their books, NOPAT is the same as net income. However, for many large companies, there are many ‘below the line’ items like income from discontinued operations, minority interest or interest income, which do not reflect the profitability in core operating activities.

In the denominator, we use invested capital, for which we start with the net working capital by subtracting the current liabilities from the current assets. We then subtract the cash which is in excess on the books from the net working capital. The non-cash working capital is then added to the net fixed assets (Net PPE), also known as long-term or non-current assets. This is essentially the net operating capital invested in the company to run its day-to-day operations.

ROIC: Link to Value Creation 

When a company builds a plant, buys vehicles or machinery of any kind, it chooses to invest cash into that asset, assuming it will contribute to the operations and will thereby help in increasing the profits. A high ROIC company is one that can maintain high profitability with relatively low investments as compared to its peers, thus creating value for the shareholders. But how does this create value? A high ROIC over a period eventually results in higher earnings per share growth over the long run because it takes less investment to grow the earnings. This leaves more money to reinvest into the business or distribute to the shareholders as dividend.

ROIC is considered a better indicator of value creation since it essentially does away with the shortcomings of ratios such as ROA and ROE. It considers total operating profit to both equity and debt, unlike ROE which just focuses on returns to equity shareholders. Thus, it removes the distortion that makes highly levered companies profitable using ROE. In practice, the primary reason for computing the ROIC is to compare it with the weighted average cost of capital (WACC) of the company. This is used extensively by portfolio managers who use the spread between ROIC and WACC to determine the value across investments. A higher ROIC as compared to WACC would lead to value creation and lesser ROIC would lead to value erosion.

Empirical Evidence 

We have considered 660 companies with a market capitalization of above Rs 1,000 crore in an attempt to understand the effect ROIC has on the returns of a stock. If we take a look at the ROICs of top Indian companies based on market capitalization, we find that companies that have produced higher ROIC have led to higher one-year returns on an average. The below table highlights the fact that companies (256) with ROIC higher than 20 have delivered average returns of 3.80 per cent on a one-year basis, whereas companies (232) having ROIC between 10 to 20 per cent have given average returns of negative 3.25 per cent. Similarly, companies (172) which have an ROIC less than 10 have performed rather poorly, delivering one-year average returns of negative 4.05 per cent.

Unintended Consequences of ROIC 

Clearly, ROIC is a measure that is strongly aligned with shareholder interest and value creation. This has made it all the more important for the management of any company to present good numbers to the public. However, the added pressure can have negative consequences that an investor should be aware of. It must be kept in mind that an increase in ROIC may not always indicate ‘better ROIC’. If a company has a return of 8 per cent, getting to 13 or 15 per cent may or may not always be an improvement. It largely depends on how the company gets this improvement. If the gain is attained by increased revenue and profits while maintaining disciplined investment, the gain in ROIC is genuine and the management has truly created value for the shareholders. However, if the gain in returns is obtained by forgoing good investment opportunities just because they aren’t great investments and with the sole motive of increasing the ROIC, it can limit the growth of the company.

Conclusion 

ROIC is a highly reliable and useful metric to consider when measuring investment quality. It is not readily available like other popular ratios and it takes a bit of work, but once investors start figuring out ROIC, they can be better armed to pick out stocks with great value. One should keep in mind to not just look at the level of ROIC but also the ongoing trend as a whole. A falling ROIC for a considerable period may indicate that the management is not able to pick good investments and will have trouble coping up with its competitors. On the other hand, an ROIC that is rising continuously strongly indicates that the management is making effective capital allocation decisions and helping the company pull away from its competitors. Such stocks deserve to trade at a premium to their peers, even if their PE ratios seem high.