Titan Learn: ROIC and How It Drives Stock Prices

TLDR: This is it - the one metric you should know about. It can be used to evaluate everything - from a local business idea, to a large-cap technology stock.

30-second summary
Return on Invested Capital (ROIC) is often referred to as the single most important metric in gauging a business's quality.
The Wall Street Journal once called it the "hottest metric in finance." Warren Buffett has referenced it as the defining trait of his "ideal business."
So what is it? Conceptually, you can think of it as profits divided by investments. Or in more formal accounting terms ROIC = NOPAT / Invested Capital.
While this may seem like a mouthful, the concept is actually very simple at its core. It shows is how much money a business makes (profits) for every dollar that it puts to work (invested capital).
A quick example
Imagine a friend offers you the opportunity to invest in a restaurant, saying it will earn $200,000 in revenue with $50,000 in annual profits. Would you do it? "It's a 25% profit!" Trick question. You need more information.
What's being left out of this calculation is any measure of the "dollars in" necessary to generate these "dollars out."
Or in other words, how much capital do you need to invest to get to generate this that $200,000 in revenue?
If it costs $1 million to buy and set up the restaurant's building, ovens, furniture, etc. then it wouldn't be a very compelling business. You're only making 5% ($50,000 profit on your $1 million investment) every year.
Looking only at profits is a classic mistake.
Your cheat sheet: What types of businesses have the best ROICs?
Generally speaking, businesses that don't require a lot of heavy investments to run tend to have higher ROICs. These are referred to by investors as "asset-light" businesses or businesses that demonstrate "low capital intensity."
Think: businesses that sell intellectual property (like software), or service-oriented businesses like consulting or advertising firms. You can run those types of businesses with nothing but some standard office equipment.
On the flip side, businesses that require a lot of investment to keep up and running tend to have lower ROICs.
Think: airlines and utilities companies. These types of businesses require a lots of large investments and upkeep in expensive machinery and equipment. As invested capital makes up the denominator of ROIC, it should be unsurprising that these businesses don't generate great ROICs.
Why ROIC drives stock prices
The reason why ROIC stands out versus other metrics is because it represents the most fundamental comparison in assessing any type of investment - whether it's a stock, a project, or an entire business: how do dollars in compare to dollars out?
In doing so, ROIC captures a business's underlying performance. It shows the rates of return a business is able to earn on the investments it makes. Over the long-run, that's what drives value, which is in turn what drives long-term returns in stocks.
While stock prices can be volatile and often deviate significantly from a business's underlying performance over short time horizons, over the long-term, a stock's average annualized returns tend to approach the underlying business's ROIC.
As such, it should be unsurprising that ROIC is a highly scrutinized metric for long-term oriented investors.
If ROIC is so important, why don't people talk about it more?
The reason why ROIC is less commonly referenced and used despite its importance is because the calculation involves a few additional steps, often requires some adjustments, and isn't provided in most standard financial databases.
Compared to other more straightforward metrics, ROIC involves a bit more art than science. That said, even a rough calculation of ROIC can be very informative. As an investor, you're a business owner. And as a business owner, understanding the return profile of your business should be one of your top priorities.
Appendix: The nitty gritty
So how do we like to calculate ROIC?
The numerator, NOPAT, represents after-tax profits. It's relatively straightforward to calculate: Operating Profits * (1 - Tax Rate)
The denominator, Invested Capital, represents all of the money that has been invested in the business.
This is a very simple concept, but for large corporations with complex balance sheets, it can be more complex to tally up than you'd imagine.
There are numerous ways of calculating it, but we think the most straightforward is Total Assets - Excess Cash - Non-Interest-Bearing Liabilities.
A mouthful, we know. But as always, don't hesitate to reach out if you have any questions.
Jun. 21st, 2019
The statements, opinions and analyses presented herein generally are provided as general information. Opinions, estimates and probabilities expressed in Titan research constitute the judgment of the author as of the date indicated and are subject to change without notice. While all the information prepared in the foregoing articles is believed to be accurate, Titan Invest (“Titan”) makes no express guarantee as to the completeness or accuracy of, nor can it accept any responsibility for errors appearing in, the foregoing articles. Other events which were not taken into account may occur, and any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. The information contained herein is not, and should not be construed as, an offer to sell or the solicitation of an offer to buy any securities. In addition, nothing contained herein is intended to be, nor shall it be construed as, investment advice, nor is it to be relied upon in making any investment or other decision. While Titan is a federally registered investment adviser, the information presented is not part of the personalized, proprietary algorithmic based investment advice provided by Titan to its advisory clients. Rather, the information presented constitutes educational and informational materials meant to better inform market participants, including, without limitation, current and potential advisory clients of Titan. Prior to making any investment decision, you are advised to consult with your broker, investment adviser, or other appropriate tax or financial professional to determine the suitability of any investment. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy discussed herein will be profitable or equal any historical performance level(s). Neither Titan, any of its affiliates, nor each of their respective officers, directors, members, agents, representatives, employees, or contractors (collectively, “Titan Parties”), shall be responsible or have any liability for investment decisions based upon, or the results obtained from, the information provided herein. You assume all risks of loss resulting, directly or indirectly, from the use of the information contained in the foregoing articles. By accepting receipt of the foregoing articles you acknowledge and agree to hold harmless the Titan Parties from any and all claims, actions, damages, losses, liabilities, costs and expenses of any kind whatsoever, including but not limited to any claims of negligence, arising out of, resulting from, by reason of, or in connection with the use of the information contained in the foregoing articles. Securities laws impose liabilities under certain circumstances on persons who act in good faith, and therefore no portion of the above shall constitute a waiver or limitation of any rights you may have under any federal or state securities laws.
Certain articles discuss historical performance of a particular issuer over a limited period of time. The historical performance discussed in such articles represents gross performance of the issuer over the limited period of time depicted, and is not indicative of any actual portfolio or investment returns of any account. Any such returns, even if an account was invested in the security discussed over the limited period of time depicted, would be reduced by fees and expenses paid by any such account. The foregoing articles contains certain “forward-looking statements,” which may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, without limitation, estimates with respect to financial condition, market developments, and the success or lack of success of particular investments (and may include such words as “crash” or “collapse”). All are subject to various factors, including, without limitation, general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors that could cause actual results to differ materially from projected results. Comparable companies, strategies, portfolios and indices may be included in the foregoing articles only as a context reflecting general market results during the depicted period or as of the specified date. The comparison of any company, strategy, portfolio or index to a single other company, strategy, portfolio or index may be inappropriate because the relevant assets, strategies and level of risk may vary materially from the comparable company, strategy, portfolio or index as a whole. Titan uses a proprietary algorithmic strategy in selecting recommendations to advisory clients. Issuers and/or securities discussed herein may be, and often are, held by clients of Titan in their investment portfolios. Any single security or issuer identified in herein will not represent all of the securities purchased, sold or recommended for advisory clients of Titan. Please see Titan’s website and Program Brochure for more details on security selection for advisory clients. Before investing, consider your investment objectives as certain investments are not suitable for all investors. Past performance is no guarantee of future results.
© Copyright 2018 Whisker Technologies, Inc. All rights reserved.