Intuitive way to think about ROIC?

Hey guys - would love to hear if anyone has an intuitive way of thinking about ROIC. Any general shorthands to calculate or heuristics people use to think about it across industries (e.g. sector A has a xx% ROIC across the major players) would also be appreciated. I understand the metric from a textbook perspective - essentially the effectiveness of a company in turning invested $ into profits, but I see a lot of different approaches to calculating it so am looking to deepen the understanding a bit.

Comments (9)

  • Analyst 2 in AM - FI
Dec 24, 2021 - 11:26am

Not too helpful and I acknowledge that there are a number of minute calculation or interpretation differences, but I'll point you to chapter 8 in McKinsey's Valuation book. You should be able to find a pdf online if you don't want to buy it or don't have it. Pretty good summary and should be what you're looking for

  • Intern in AM - Equities
Jan 8, 2022 - 6:04pm

FCF/Sales x Sales/Invested Capital = FCF-margin x Invested Capital Turnover Rate = ROIC 

Simplified and basically Business/Finance 101, but I've found the framework helpful when learning new sectors/businesses. Really digging deep into each variable, why is the way it is, what has changed over historical #'s, what is likely to change and how does it comp to peers? Simple but effective to build a view on ROIC, as is just reading statements and asking why for each line item. 

Most Helpful
Jan 9, 2022 - 8:51am

NOPAT Margin and IC Turnover, as someone else has already mentioned, are always good to look at. They should square with the economic reality of the business.

For example, a company like Costco has razor thin NOPAT margins but turns its IC over substantially more than other companies to derive its ROIC. This is what you would expect as that is their business model (low prices, high inventory turns and sales per sqft). Conversely, a company like IDXX is has very high NOPAT margins and turns IC over relatively more slowly. Again, squares with the economics and model of the business (sells high margin capital equipment and consumables into the vet market, long useful lives). 

Another heuristic that I like to use when I listen to pitches from other analysts in my group as it pertains to valuation is that ROIC/WACC is a decent no-growth proxy for EV/IC (or like a better Price to Book). For something like banks, the equivalent would be ROE/COE as a proxy for P/B where P/B has more validity as a multiple. Mentally, I can quickly do that math and compare this sort of no-growth multiple to the actual EV/IC multiple to get a sense for how much growth is priced into the market price. 

Another thing to remember that is useful for looking at other analyst's models is that a company with high ROIC will be most sensitive to changing growth expectations (as well as the sustainability of that high ROIC - read up on fade rate), while a company with low ROIC will be most sensitive to changing ROIC expectations (which can be driven by either margin expectations, expectations for reinvestment, or some combination of both). A company with low-ROIC will improve its valuation the most by improving its ROIC, while a company with high-ROIC will improve its valuation the most by growing. This is all articulated better in McKinsey, but think of return on capital as the value creation machine. The machine runs on growth. You can either create more value by feeding the machine more growth, or improving the machine itself to be more productive and efficient with the growth you feed it.

A sweet spot for me as a quality-oriented investor with a valuation discipline is to look for competitively advantaged companies and high-quality business models (both qualitative components of structurally high ROIC) where growth expectations priced in are too low, or at least give me favorable risk-reward vs what I believe the company can produce. I like these situations because you get the downside protection from the high business quality (flight to safety bid in a sell off), but also the valuation upside IF/when growth proves to be better than expected. These companies just also tend to compound at higher rates over longer periods of time, which fits well with the long-only strategy we run.

A final note is that you need to be cognizant of the difference between structurally high ROIC and cyclically high ROIC. I learned this lesson early on with a company I got involved with when I was less experienced and first starting out on my business quality journey (converting from more of a classic value beginning). At purchase, ROIC was in the 20% + range and had been expanding on top of good growth, yet the company traded at a very reasonable multiple. This is because the company was/is very cyclical and its ROIC was inflated because it had a lot of operating leverage and we were at a high point in the cycle. When the cycle turned, that ROIC evaporated. This is especially pertinent in today's environment with a lot of companies producing the illusion of pricing power due to the ongoing supply shock we are still trying to recover from. 

Whether a company has cyclical or structural ROIC will be an output of your evaluation of the moat and its sustainability (also some sort of fixed cost analysis will uncover the degree of operating leverage in the model). 

Jan 10, 2022 - 6:24am

When ROIC is greater than WACC the company is creating value in excess of the capital it has invested into its operating assets (and the return required by investors to provide that capital to the company). Any multiple is driven by ROIC, growth, and risk (WACC). If you isolate two of the variables, you can get a sense for impactful the third is to the valuation (from a multiples perspective). Just a quick way to get a feel for a valuation when its a company that you don't really follow. 

Jan 10, 2022 - 3:17pm

really great comment. I was wondering if you could disclose the company that had the artificially high ROIC and turned bad once it moved off peak-cycle; im currently looking into a potential play that mirrors that said pattern

  • NA in IB-M&A
Jan 9, 2022 - 8:55am

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