I like to get a handle on capital productivity for a company pretty early in the process of working on a stock because I am simply not going to own something unless I am excited about its ROIC level. Sure, it may not be sustainable, and the stock may be trading at a price that is too high for that capital productivity, but feeling good about the company’s ROIC is somewhat of a gating issue. If the business can’t earn economic profits, and I don’t have the threads of a thesis (see ROIC thesis buckets here) on why that will change for the better in the future, I am on to the next one.
With this in mind, I have attached a template I use for looking at a company’s ROIC – maybe you will find it useful and will modify it for your own purposes. Let me know your suggestions for improvements!
In early 2023 I was looking at a UK company called Smith & Nephew PLC. It makes medical devices – mostly orthopedics. My take (everyone has their own) was that the truly comparable companies are Zimmer Biomet ZBH 109.47 +1.44 +1.33% and Stryker SYK 381.11 -3.91 -1.02%. For ROIC comps I try to not go crazy with too many companies because putting them together is a fair amount of work.
Below is a grab of the summary screen for these comps. Double-click on the grab to enlarge it so it’s readable – same for all of the following grabs in this post and on the rest of this blog. The excel sheet itself is also embedded at the bottom of this post.
The top part is a summary of what each business does and a bit on each’s segment mix. This is important for a variety of reasons, including that we have to know how truly comparable these businesses are in their operations and revenue/income generation when comparing ROIC levels.
The time series graphs show ROIC (including and not including goodwill and other intangibles) and the amount of invested capital for each of the last five years through 3Q22. You can see the supporting data in the embedded excel sheet below.
Some quick takeaways:
- This is a good example for ROIC comps in that the capital productivity of these companies is very different depending on whether or not goodwill and other intangibles are included in invested capital. You can see that if they are, ZBH and Smith & Nephew don’t seem to earn their cost of capital (or, barely make any economic profit) while SYK does. But when goodwill and then other intangibles are taken out, they do seem to make economic profits, at least looking quickly. But generally speaking the answer to the question “does this sector allow companies to make good economic profits?” is probably yes, at least for now.
- This is the case because these companies (more ZBH and SYK) tend to do a lot of acquisitions, and goodwill and other intangibles land on their balance sheets because of that. They would say they are executing what is essentially a valuation multiple arbitrage – they buy small companies with a single product or just a few at low absolute valuations and then tap them into their distribution networks while taking out the redundant corporate overhead expense, and their shareholders pay a higher multiple for this. Or at least that’s the idea. Many people (including myself) are skeptical of highly acquisitive companies – usually value is destroyed through acquisitions – but in this industry, I am more inclined to accept that acquisitions, when done with valuation discipline, can be accretive.
- Don’t forget that the level of invested capital for each company (the bar graph) is important – we want businesses that can earn high returns on incremental capital and that have opportunities to continue to put that capital to work.
- ZBH spun off part of its spine and dental products (ZimVie) in March 2022. These were small parts of its business, but it made its asset base decline from 2021 to 2022. You can see a break-out of the income and assets related to the spinco in ZBH’s 2Q22 10Q (page 8 – Discontinued Operations). This is the kind of thing to be mindful of when comparing ROICs – numbers can be skewed by transactions, large asset write-downs, etc. Many boards are highly cognizant of ROIC and will seek to get rid of low ROIC businesses and the assets related to them to try to improve ROIC in the core business; a spinoff is a great way to do that. As I said, there is a lot going on here when you are looking at several companies over 5 years – that’s why I like to limit the number of companies for ROIC comps. It would be a mistake to blindly use a comp set from Bloomberg/CapitalIQ or a sellside research piece for ROIC comps – make your own based on the businesses, and keep the list short.
- I don’t want to get into valuation but…it’s fair to say that SYK’s superior ROIC is reflected by a substantially higher market multiple than SBH and Smith & Nephew. Understanding what is driving the changes in these bars in the time series is important
- This sheet should be used as starting point for thinking about what drives normalized ROIC and reinvestment for these businesses. I created the sheet because I was looking at Smith & Nephew, but sometimes ROIC comps will make me switch my focus and interest to another company in the comp set, and that’s great, in my opinion, because it still means that wherever I end up, my investment decision is rooted in some kind of capital productivity thesis
Here is the full excel sheet: