Return on Invested Capital (ROIC) is a concept that I have been reading about recently. Bruce has mentioned it here a few times, and there has been some discussion about it on the Fool boards, where college student Andrew Chan posted a paper about ROIC. I think it is an important concept that we should explore further. Later in this post I will show a link to a spreadsheet and suggest that a few volunteers step forward, but first some background.
The value of using ROIC is that it is said to be a better measure of performance and value than other more familiar measurements such as sales growth or even earnings growth or PE ratios. The basic concept is pretty simple: a company needs capital in order to operate, and it uses that capital to (hopefully) generate a return. The higher the return the better it is. Naturally, there is a cost to acquiring capital, and in order to create value a company must generate a return on its capital that is greater than the cost of its capital.
A little illustration to clarify that last point. Lets say I want to start a company to sell T-shirts at a flea market. I borrow $10,000 from my favorite uncle, buy the shirts and sell em. So I use the full $10,000 to buy shirts, I sell them all for $25,000 and at the end of my first quarter, after expenses I'm left with $11,000 cash. Business looks good, so I plow ahead. I buy $11,000 worth of shirts, sell them for $28,000 and after expenses my second quarter's profit is $14,000.
Lets crunch the numbers: my sales increased from $25,000 to $28,000 which is 12% sequential growth. My profits grew from $11,000 to $14,000 up close to 30%. Looks pretty good, except that the agreement I signed with my greedy uncle called for $1000 per month in interest on the $10,000 loan and after six months I now owe him $16,000 and all I have is $14,000 so instead of creating value my company has destroyed value. That's despite the fact that I showed good sales growth, nice profit growth, high gross margins, and a nice PE ratio.
Now in real life, most public companies do not borrow their capital from a greedy uncle. They obtain it from the equity markets, bond markets, banks, etc and there is a relatively narrow range regarding the cost of capital. However, the return on capital can have a huge range. Some companies have negative returns, some have near zero returns and others have whopping high returns.
So what we want to do is to make sure the companies we are interested in have nice high returns, and preferably we want to see the trend of those returns increasing.
Unfortunately, unlike the calculation for sales growth or the calculation for a PE ratio there is little general agreement on the method for calculating ROIC. Every paper I have read uses a different formula and the reasons and justifications can make your head spin. Andrew Chan, who I mentioned above, stated that he keeps modifying the method he uses. However, finding the ultimate calculation method is not the key issue. If we pick one method and use it consistently we can compare company to company and examine trends.
I have reviewed a number of formulas and I came across one spreadsheet that I think is incredibly good. It has been offered to all by a generous soul who posts on the Fool under the delightful handle of madmarv. It can be found here:
geocities.com
The spreadsheet is the first one listed, "financials.xls" and it is also offered in a zip format for those who need a quicker download. It does not just calculate ROIC, but also a ton of other measurements and it has neat features such as highlighting in red trends going in the wrong direction.
Unfortunately, like many worthwhile things, it takes a good bit of effort to utilize the spreadsheets. You have to get a company's quarterly and annual reports and plug in the numbers.
If any of this sounds of interest to you and you think you might like to fill in the numbers for a company of your choice, let me know. Instead of each of us plugging in numbers for a dozen companies we could do one or two each and share the results. We might make some interesting discoveries along the way. And on the other hand, if any of you spreadsheet/financial wizards find something very amiss with Mad Marv's model please let me know.
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