Skip to main content

Understand ROIC Better

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

Popular posts from this blog

How Food Delivery Apps Make Money

Third party food delivery is proving to be a tough business space with minimum option to differentiate, tight profitability margin and intense competition that is putting the industry in the process of more and more consolidation.  When Uber started and turned into something that people would use everyday, it became obvious that the idea of moving people from Point A to Point B with the help of an app would branch into Uber for other services like food delivery, groceries or any other parcel. The world of convenience economy was only about to expand. Like Uber, an app would connect merchants to consumers via riders. The app is a platform that help connect these three parties that are required to make a transaction and shipment. The space that was ripe for disruption in this convenience economy was restaurants. Most restaurants didn't have their own delivery logistics. There were only few exception that you can think of that had their own delivery logistics. They had so because they

What to Look for in a Cash Flow Statement

Cash flow statement demonstrates the flow of cash coming into a business and going out from a business. It differs from income statement because cash flow statement is recorded on a purely cash basis. In income statement, if a business booked a sale of a product or a service and was yet to receive cash from the customer, the business would record it as sale in its income statement. On the other hand, if the business purchased raw materials for the products they sold or incurred cost for the service they provided, they would record this expense as cost of sales or cost of service regardless of whether the transaction was on a credit basis or cash basis. This method of accounting is called accrual accounting which is the most used method of accounting for income statement. So, cash flow statement gives you a different perspective. Since, it records how much cash is coming into a business and going out from the business through operating activities, investing activities and financing acti

Understanding Free Cash Flow

When I was first introduced to the concept of 'free cash flow' back in my BBA program, I didn't grasp it as clearly as I should or could have. I blame myself for not putting in enough effort to understand the concept back then.  Now that I have spent a considerable amount of time using ‘free cash flow’ as one of the major valuation methods, I can see how this concept can be learned in an effective way. In this article, I attempt to explain how businesses generate free cash flow, what it means to investors, and why and how free cash flow is used in company valuation. The Basic In a nutshell, free cash flows are the cash flows available for distribution to suppliers of capital . When we consider free cash flow to the firm (FCFF), it is the cash flow available to both debtholders (those who lend to the company) and stockholders or equity holders (those who buy the stock of the company or have equity ownership of the company). And when we consider free cash flow to equity

History of Money and Monetary Systems

From ancient Rome to modern world, money has gone through an evolutionary process. For the Roman empire, scarcity of silver and gold meant resorting to debasement to create new money. For the Inca empire, the same silver and gold was sacred precious metals coming from the hand of God. Spanish empire hunted for these precious metals to accumulate power but in truth abundance of silver lowered the value of the metals for which they had unquenchable lust. But over the course of time, the concept of money turned out to be a simple narrative installed in the minds of the people. The truth of the matter is, be it gold or silver or simply a piece of paper or the digits in your mobile wallet, the money has the value only if other people value it the same way. It's a machine driven by trust. The narrative of money has made a significant contribution to the progress of humankind. Although It was often flawed and we are yet to find a perfect system, the concept of money was one of the greates

How Pinduoduo Made it Big | History of Pinduoduo

Alibaba (Taobao and Tmall) and JD was dominating the China e-commerce space and no other company was able to match their scale until a new company emerged with an aim to serve the tier 3 and 4 cities that remained underserved. It focused on perishable products and daily necessities to make sure the users have high purchase frequency and it was also their category of choice because of low competition. It growthhacked its way by offering group buying feature at too good to believe discounts. It took it to the next level by focusing on interactivity by making the app browsable for fun and rewards. The company’s IPO prospectus referred to the platform as mix of Costco and Disneyland, the pricing is the Costco part and the fun browsing is the Disney part. Pinduoduo built a recipe for building a social commerce platform that mimicked the way people shop offline. It took cues from the gaming world to entice users to spend time on the app. All these viral elements made Pinduoduo the largest e