ROIC vs Returns
My team is comparing ROICs of three different companies in the same industry over a multi-year period (8-10 years). We have found a weaker correlation between the stocks’ returns and the average ROIC over the same period, where the company with the highest ROIC has actually performed the worst in the market. Beyond incorrect calculation, what are some of the potential reasons for this?
My thoughts:
If you give more color on the ROIC components for each company other things might come to mind.
This is excellent. How would you compare ROIC to ROE and ROA? How should investors think about them and use them, and are some more important than others in certain scenarios?
ROIC is the gold standard & what you should be mainly using, and it also has the huge advantage that it pairs directly with WACC to tell you if a company is meeting its cost of capital. ROCE is a close variant you'll often see management team's using to benchmark their own performance but as an investor I would stick with ROIC.
ROE shouldn't be the main metric you rely on since it gets massively distorted by how much debt a company takes on (e.g. is this really a business that's creating more value than peers or just one that's levered itself up to its eyeballs?), but it doesn't hurt to use it alongside ROIC since a sensible amount of debt can indeed improve returns for the equity holders.
The only thing ROA has going for it is that it's standardized & easier to calculate (since both net income and total assets are reported numbers vs 'theoretical' values like NOPAT and IC that you won't find anywhere in an annual report). Maybe other people have a different view on this though.
ROIC just overrated and noisy IMHO. I know a lot of professors and value guys treat it as a more insightful metric but I just don’t see it.
There’s so many ways to imagine that kind of a ratio misleading you, but maybe the simplest way is to think of a high growth tech company. It’s market cap today is a lot higher than it’s IC. Now let’s say over the next year it generates a disappointing level of EBIT (20% below expectation) on poor growth. It’s market cap tanks because all the future growth expectation is reduced as a result of the poor growth & low EBIT. Failed growth story, bad stock.
But ROIC will still be high because that weak EBIT was a high fraction of IC.
It’s just a screwy metric, I understand what it’s proponents are trying to get at but it’s really not too useful.
Good points from the above poster. Also have a look at what pricing did (in addition to growth and any adj. necessary to calculate the right ROIC). A high ROIC company that was priced too high can show lower stock returns despite having a higher ROIC than the comp group just because it was trading too expensive.
look at ROIIC and growth in the capital base over the same period. legacy assets aren't the full story.
ask yourself:
1. how much capital can the firm reasonably deploy over some time period
2. what can they earn on that capital deployment
if that ROIIC (not ROIC) is less than wacc then they are destroying value.
also if expectations were high for the high ROIC company and they were earning ROIICs below ROIC then you should see derating in the multiple as the value of future growth becomes less valuable i.e. lower spread.
lots of ways to slice and dice. disaggregate returns and analyze the drivers.
GL
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