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Understand ROIC Better

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ROIC (Return on Invested Capital) is one of the most important indicators to assess a business. It doesn't only tell about the profitability of a business, it also reveals how efficiently the business is allocating its capital.

To calculate ROIC, in the numerator, there is NOPAT (Net Operating Profit after Tax), which indicates how much money a business made in a specific period, and in the denominator, there is the cumulative amount of invested capital (debt and equity).  


ROIC = NOPAT/Invested Capital

The higher the number, better for a business. 

Understand ROIC Better by Md Nazmus Sakib

How does a business generate a high return?

If we break down ROIC, we can get this: ROIC = (NOPAT/Sales) * (Sales/Invested Capital). We can take high ROIC businesses and break their ROICs into these two parts. 

NOPAT/Sales indicates NOPAT margin, which measures profit per dollar of sales. Generally, a high margin indicates a differentiation strategy. When a company has a differentiated product on the market, they can charge a higher price, which results in a higher margin. 

Sales/Invested Capital indicates invested capital turnover, which measures sales per dollar of investment. Generally, a high invested capital turnover indicates a cost leadership strategy. When a company can offer a product at a lower cost than its competitors, it can make higher sales in the market with the same amount of invested capital.

When NOPAT margin drives a business’ ROIC, most of the time it’s because of differentiation strategy, and when invested capital turnover drives ROIC, it’s because of the cost leadership strategy.

In the chart below (taken from one of Morgan Stanley Investment Management Reports), companies with relatively high margins and low capital turnover are assumed to have differentiation strategy, and companies with low margins and high capital turnover are assumed to have cost leadership strategy. Two companies can arrive at the same ROIC via different drivers.

Source: Morgan Stanley Investment Management

ROIC and Economic Moat

Warren Buffett said, “A good business is like a strong castle with a deep moat around it. I want sharks in the moat to keep away those who would encroach on the castle.”

Let’s understand how we can find out if a business has an economic moat using ROIC.

For this, ROIC needs to be compared with WACC (Weighted Average Cost of Capital: combined cost of debt and equity). WACC can be considered the next best alternative rate of return a business can generate with same risk by investing elsewhere. You can think of it as opportunity cost of the investment in current business. So, WACC is the threshold of return a company must meet to create value.

If ROIC is equal to WACC, a $100 investment is worth $100. And if ROIC is higher than WACC, a $100 investment should be worth more than $100, and vice versa. So, a business only creates value when ROIC is higher than WACC.

The greater the ROIC - WACC spread, the greater the value of the investment.

Let’s say a business is consistently generating positive ROIC - WACC spread. The law of regression to the mean (RTM) states that the business’ ROIC will decline towards the WACC and the spread will vanish. The theory is that when a business consistently generates an ROIC greater than its WACC, it faces competition from new entrants as new investors find the industry to be a profitable space.

But if the business defies the law of regression to the mean and continues to generate positive ROIC - WACC spread for a long time, it’s because the business has an economic moat. The business may have a differentiated product that is hard to replicate, a low-cost production facility or process that very few competitors have, a network effect, a strong brand, etc., or it may operate in an industry where barriers to entry are high.

One way to measure if a business has an economic moat is to measure that business’ rate of RTM. The lower the pull of RTM, the stronger the economic moat of a high ROIC generating business.

For investment, we should focus on what will happen in the future. History gives us some ideas about a business, but we want to evaluate how the business will perform in the coming days.

If our assumption is that the business will consistently generate ROIC greater than WACC, we need to ask if the business has any economic moat that will allow it to defy the law of RTM. If these things don’t hold true for the business and the business generated a positive ROIC - WACC spread in recent periods, the most likely scenario is that the spread will not sustain for long.

It explains how a business develops economic moat or competitive advantage

ROIC and Shareholder Return

Does a high ROIC ensure shareholder return? Not really. If a business’ ROIC follows market expectations that are already priced in the stock, it won’t create any shareholder return. 

However, if there is a revision in expectation that ROIC will be higher or that a high ROIC will persist longer than earlier estimated, then shareholder return will increase. 

You have to first estimate what expectations are embedded in the stock price. If you anticipate that a business’ high ROIC will persist longer or improve more than the market expects and your forecast is spot on or close enough, you will most likely make a good return on that stock.

Supporting Read (mentioned below):

1. Return on Invested Capital: How to Calculate ROIC and Handle Common Issues

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