Returns on Invested Capital

Returns on Invested Capital (also known as 'ROIC') is a profitability ratio that measures how efficiently a company is using the money invested in its operations to generate profits. Think of it as the ultimate report card for a company's management. If you gave a CEO €100, how much profit could they generate for you in a year? ROIC answers that question. It calculates the return generated from all capital providers, including both shareholders and debtholders. This provides a holistic view of the company's ability to allocate capital wisely and turn it into real, after-tax profits. For value investors, ROIC is one of the most important metrics because it cuts through accounting fluff and gets to the heart of a business's quality. A company that can consistently generate high returns on its invested capital likely has a durable competitive advantage, or what Warren Buffett calls an Economic Moat.

Profit is good, but profitability is king. A company can make billions in profit, but if it had to invest trillions to do so, it's not a great business. ROIC puts profit into perspective. It's the tool that helps you distinguish between businesses that simply grow bigger and those that genuinely grow richer. As the legendary investor Charlie Munger wisely noted, “Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns.” If a business consistently earns 6% on its capital, your long-term return as an investor will likely hover around that same 6%. But if a business earns a stunning 20% on its capital year after year, you've found a potential compounding machine. A high and stable ROIC is often the clearest quantitative sign of a high-quality business with a strong competitive advantage that protects it from rivals.

The classic formula is beautifully simple: ROIC = Net Operating Profit After Tax (NOPAT) / Invested Capital Let's unpack the two key ingredients.

NOPAT represents the company's potential cash earnings if its Capital Structure had no debt. It's the profit generated from a company's core operations, after taxes, but before accounting for interest payments. This makes it a fantastic tool for comparing the operational performance of different companies, regardless of how much debt they use. The calculation is straightforward:

• NOPAT = Operating Income x (1 - Tax Rate)

Invested Capital is the total pool of money raised from both shareholders and lenders that a company has used to fund its assets and operations. It's the “skin in the game” from all financial backers. While there are several ways to calculate it, a common method is:

• Invested Capital = Total Debt + Shareholder Equity - Cash & Cash Equivalents

Why subtract cash? Because excess cash sitting in a bank account isn't actively being used in the company's core operations to generate profit, so we exclude it to get a clearer picture of operational efficiency.

A good ROIC isn't just a number; it's a number that exceeds the company's Weighted Average Cost of Capital (WACC). The WACC is the average rate of return a company is expected to pay to all its security holders to finance its assets.

• If ROIC > WACC: The company is creating value. Every dollar invested is generating more than it costs. This is the sweet spot.
• If ROIC < WACC: The company is destroying value. It's like borrowing money at 8% to invest in a project that only returns 5%.

As a general rule of thumb, a business that consistently achieves an ROIC above 15% is often considered excellent. However, what matters most is the trend. A value investor looks for a high ROIC that is stable or, even better, increasing over a period of at least five to ten years.

You might have heard of other profitability ratios like Return on Equity (ROE) and Return on Assets (ROA). While useful, ROIC is often considered superior for a few key reasons:

• Return on Equity (ROE): This measures the return for shareholders only. A company can easily boost its ROE by taking on a mountain of debt. ROIC, by including debt in its calculation of Invested Capital, isn't fooled by this financial engineering.
• Return on Assets (ROA): This measures how efficiently a company uses its assets to generate earnings. However, it doesn't distinguish between how those assets were financed, and it includes non-operating assets. ROIC focuses purely on the capital invested in core operations.

In short, ROIC provides the purest picture of a company's underlying operational profitability.

ROIC is a powerful metric, but it's not a magic bullet. Always remember:

• It's a snapshot based on historical data. The future could be different.
• The calculation can vary slightly depending on the source, so consistency is key.
• It's less useful for certain industries, like banks and insurance companies, which have unique business models and capital structures.

Your job as an investor is to use ROIC as a starting point. If you find a company with a stellar ROIC, the next question is always: Why? Understanding the source of that high return is the secret to true value investing.