# The Concept of ROIC.

In some of our previous texts we’ve referred to Return on Invested Capital (ROIC). Today we’ll do a deep dive into the concept of ROIC and its’ importance for investment decisions.

ROIC Calculation.

Unfortunately there is no generally accepted way to calculate ROIC. One could usually find different approaches for calculation of both numerator and denominator of this ratio.

For the calculation of numerator we suggest to use NOPAT (Net Operating Profit After Tax) or EBIT (Joel Greenblatt uses it in his Magic Formula).

Invested Capital.

Invested Capital is a denominator of ROIC ratio. It is not uncommon to see Total Debt + Shareholders Equity formula for Invested Capital calculation. But this formula may distort the view of company’s business operations. We suggest to use Joel Greenblatt’s way to calculate Invested Capital. Invested Capital = Net Working Capital + Net Fixed Assets. Net Working Capital is calculated as Current Assets — Current Liabilities + Short Term Debt — Excess Cash. Excess Cash includes the part of Cash & Equivalents that exceeds the difference between Current Assets and Current Liabilities of a company. Net Fixed Assets are calculated as Non-Current Assets — Intangible Assets. In some cases it is reasonable to use Goodwill instead of Intangible Assets, for instance, when Intangible Assets are important fro company’s operating activity.

ROIC and ROIIC.

When looking at ROIC of a company is important to understand that it represents return on invested capital that was accumulated through the entire operating history of a company. Thus ROIC helps to understand how efficiently company uses invested capital that was formed in the past. But this gives us little understanding of company’s future. If we want to get some sense of company’s future than it is much more important to look at ROIIC (Return on Incremental Invested Capital). This ratio indicates what return a company will get on new invested capital. If a company is able to invest in its’ business lots of capital with high return than its’ intrinsic value will rise.

We can employ ROIC and ROIIC to make a useful classification of business types.

Type 1. High ROIC, High ROIIC, capital-light business.

This type of business may be called an ideal. It doesn’t require lots of new invested capital but operating results are still growing. This business can distribute substantial part profits among shareholders as dividends or share buybacks. In some rare cases it is reasonable for such a company to employ accumulated cash for acquisitions. These cases should be rare because the business of a company is already exceptional. So it should be difficult to find acquisition targets that would not «diworsify» the business and destroy shareholders value.

Unfortunately, it is quite often that such a company accumulates profits as a cash on the balance sheet (i.e. uses it inefficiently) or even worse, it starts to make ill-judged acquisitions.

See’s Candies in 1970s in the perfect example of type 1 business.

Type 2. High ROIC, High ROIIC, capital-intensive business.

The difference between companies of type 1 and type 2 is that type 2 companies should invest lots of capital in their business in order to grow. This type of business is not ideal since it requires significant capital investments, but still it is one of the best that you could imagine.

It is common for such a company to reinvest substantial part of profits back in the business. So shareholders should not expect high dividends which wouldn’t be to their benefit in any case. It would be very difficult to find alternative investments with the same potential rate of return as company’s ROIIC.

Type 2 business example today is Starbucks.

Type 3. High ROIC, Low ROIIC.

Type 3 companies have their rapid growth phase, but that is in the past. They’ve lost the ability to reinvest capital in the business with high rate of return. That doesn’t mean that the business is bad. On the contrary, current operations of such a company are highly profitable though they don’t have much potential for growth. Type 3 companies are often called «cash cows».

It is only logical for type 3 companies to distribute almost all profits among shareholders. The source of potential growth for these companies is are acquisitions. But keep in mind the same principle applies to type 3 companies that we’ve discussed for type 1 companies. It is difficult to find an acquisition target that will provide both adequate growth potential and high ROIC.

Large telecom providers AT&T and Verizon are great examples of type 3 business.

Type 4. Low ROIC, High ROIIC.

Type 4 business is usually represented by small companies that don’t have rich history of highly profitable operations but they enter in a phase of rapid growth. Small pharma companies that have got a patent and drug approval are great examples of type 4 business. And. Of course, these companies should reinvest all of their small profits back onto the business.

Type 5. Low ROIC, Low ROIIC.

This is the worst type of business that is ironically usually requires a lot of capital investments to stay alive. Type 5 companies may be found in highly competitive, cyclical industries, such as automakers.

ROIC and investments decisions.

ROIC and ROIIC are usually the most important factors that should be taken into account when assessing quality of business. So it is quite obvious, that any investor would prefer to own stocks of type 1 and type 2 companies, other things being equal. Intrinsic value of such companies should rapidly grow and hence the stock price should grow as well.

But there is no «other things being equal» in reality. Stock of type 1 and type 2 companies are usually traded at very high multiples which would be corrected if there would be some business problems. In other words, there is no Margin of Safety.

Magic Formula is exactly based on the idea of finding type 1 and 2 stocks at reasonable prices (but Magic Formula approach may often find type 3 stocks since it doesn’t take ROIIC into account).

In a very rare case the market will provide type 1 or 2 stocks at attractive prices (i.e. with Margin of Safety). In this case an investor should act decisively and put large part of assets in the stock.

ROIC and moats.

ROIC calculation is easy because it is based on the past data. ROIIC estimation is a much more complex task, because here we try to make some assumptions about the future.

The market is a harsh system where the law of regression towards the mean has a full force. High ROIC business attracts competition that leads to decrease in ROIC. That is why it is so difficult to assess company’s future even if it seems that the company has great prospects.

In this situation investor can look at the concept of economic moat for a help. This concept is used by Warren Buffett. According to this concept the business should have not only good ROIIC prospects but also a sustainable competitive advantage to defend its’ ROIIC and resist the law of regression to the mean.

Popular brand, scale effect and network effect are the examples of economic moat.

Conclusion.

ROIC is a crucial element of fundamental analysis. But investor should give more close attention not to the past results but to the future (ROIIC). And besides good growth prospects a company should also have a sustainable competitive advantage to protect and enhance its’ market position.

The stocks of such companies a rarely cheap enough to provide Margin of Safety. But sometimes they are and investor should work hard to find them and get the reward that they provide.

PortfolioAnd.Me – is a platform for the analysis of stocks and investment portfolios using artificial intelligence, as well as search and compare of shares and ETFs, backtesting and fundamental company data.