What We Have So Far on Return On Invested Capital

, , ,

We’ve gotten a bit into the weeds on ROIC and will go further, but now is a good time to review why we are doing this:

The purpose of looking at ROIC is to try to understand the rate and quality of the earnings that the business’ assets provide to all capital providers for the business.  Investors are basing this on the business’ use of its assets historically, as it may inform the productivity level of those assets in the future, and/or new assets that the company buys/develops and puts to work in the future.  We are looking at the past to make an informed bet about the future, but of course, there are no guarantees because everything is always changing for companies and everything else in the universe.  

Absolute vs. Relative ROIC

We are interested in this productivity level both from an absolute standpoint (we want a healthy ROIC “spread” above the cost of capital/our opportunity cost (aka economic profits, and the spread tells us the magnitude of the advantage(s)) but also a relative standpoint, because it’s useful to compare one company’s capital productivity to its peers, or other investment opportunities you may have for your precious and limited capital. It’s also a potentially useful way to measure the effectiveness of management. Either way, ROIC is telling us something about the business’ propensity to create value, which is the holy grail of investing. 

Here’s a great visual from Beyond Earnings: Applying the HOLT CFROI and Economic Profit Framework for the ROIC formula that ties together nicely what has been discussed so far:

Notes for applying the HOLT CFROI and economic profit framework within the ROIC formula.

Onward and upward to more details on calculating ROIC in the next post, which covers the Operating vs. Financing approaches for the ROIC denominator.

Please email me with questions/comments/errors related to this post!