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.
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
Yup, I found an older version I think and the ROIC chapter is exactly what I was looking for. The fundamentals chapter was good too. +sb
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.
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).
This is really helpful. Do you mind explaining why ROIC/WACC would be a no-growth proxy for EV/IC? They seem like very different ratios - return to cost of capital vs. market value to book value
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.
I wanted to SB this, but realized I SB'ed it already.
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
Great response - how would you think about Return on Gross Investment? Is it a useful metric / if yes when as compared to ROIC?
I prefer to look at IC because you capture the effects of NWC better. A lot of companies run negative NWC these days, which is a feature of a lot of either digital businesses (software with heavy deferred components), or firms with a lot of bargaining power over their suppliers/customers (which often manifests as extended payables relative to receivables). Effectively negative NWC means that suppliers and/or customers are funding the company's growth, which I think you want to capture in any returns-based measures of efficiency and/or profitability as it means that they are getting a better return from the company's internal reinvestment into WC. Said differently, the firm requires less capital investment to grow/produce profits because customers and suppliers are providing capital. A good example is a company like Costco. Their working capital investment is predominantly inventory, but their NWC is negative because they have incredible bargaining power over their suppliers given their highly curated inventory and intentionally limited # of vendors (absurd revenue per SKU). As a result, Costco has very thin NOPAT margins, but turns its IC over enough to generate mid-to-high teens ROIC. If you were looking at gross investment I would assume a company like Costco does not look as attractive or efficient.
I like your mental model of using roic/wacc vs ev/ic to sense check how much growth is being priced in. Assuming you mean (roic-g)/(wacc-g). My issue is I don't have a good intuitive handle on g since that's growth to perpetuity, so a 20% roic and 10% wacc biz trading at 3x ev/ic implies 5% growth to perpetuity. If it were trading at 4.3x ev/ic that implies 7% g.
The difference between 5% and 7% growth into perpetuity doesn't translate into a meaningful distinction in my head. Like I'd find it hard to look at one business and say "yeah that's a 5% grower" and at another and say "that's 7%". Anyone else in the same boat?
It looks like a trivial difference when considered on an 'into perpetuity' basis, but the difference is quite material if you were to unbundle that number. This is why I prefer a three stage DCF in which you have an explicit forecast, a fade period, and a terminal value. In this structure, the fade period could be as long as 40 years. It seems silly to forecast 40 years of growth, and in fact it is if your objective is accuracy. The point is not being able to predict what will happen 20 years from now, but rather to unbundle that terminal value and try and figure out what is implied. In other words, what does the company need to produce in order to hit that 7% number vs that 5% number?
A simple way to try and arrive at these numbers would be to take your outyear from the explicit forecast and apply a simple linear fade rate to growth until the company grows at a GDP-level. So for example, say the exit growth rate at my last year of the forecast is 10%. It would be absurd to assume that a company could grow at 10% forever, but it would also probably be silly to assume that growth would immediately fall to GDP, which for the purpose of the exercise let's call it 3% is a GDP level. Instead, we can apply a linear fade rate to that 10% level to get it down to 3%. Then we can back figure out the full CAGR from start of the forecast to maturity, which should be a decent approximation of that perpetuity number. We can also vary the fade rate across scenarios and sensitize that input to get a sense of the potential range of outcomes and what would need to happen for various perpetuity CAGRs to materialize.
Again, we are not looking for accuracy, but to develop a range of outcomes for the valuation (which IMO is what valuation is, not a singular point estimate of truth). If that seems like a trivial exercise, realize that this is implied in the valuation whether you try and figure out what it is or not. Applying a 20x terminal multiple or a 5% terminal growth rate is equivalent to 'this feels right' and is really no different than the above exercise except that you made no effort to figure out what is embedded in that number.
Once you have done this a few times, you will begin to develop pattern recognition that will make a 5% or 7% implied CAGR more intuitive as to what it implies for growth and the height of the hurdle, which makes the quick ROIC/WACC check more useful.
Intuitively, ROIC is basically a form of return on investment metric and should always be viewed in comparison to WACC. If ROIC is larger than WACC then that means that the company can invest its capital efficiently (i.e. above its cost of capital) therefore is creating value. If ROIC is below WACC that means that the capital that the company is investing yields a lower return than what investors could get elsewhere for similar levels of risk, ergo, the company is destroying value.
I think everyone has a different way of calculating ROIC. It is more important to be consistent when evaluating/comparing. The way I look at:
ROIC = EBIT / Net PPE + Working Capital
It tells me how much returns are you making on the capital employed into running the business. I don't factor in interest and tax because I don't want to factor in capital structures (which you can change); and tax regime, which you usually have no control over
How do you adjust the Nopat and invested capital for IFRS16? Are right is use assets added to invested capital? If so, if and how is the Nopat adjusted?
Yeah you can add them (right of use assets) to the denominator, and it would make sense, where real estate is an intensive part of the operations, but then you have to adjust the numerator (EBIT) by subtracting the relevant interest expense associated with just the lease. Depreciation expense associated w/t the lease is already captured as you're looking at EBIT. Might be wrong here, so double check.
Agree on adding the right to use assets to the invested capital. What’s the rationale of deducting the interest expense of the lease from the Nopat?
Yeah, don't get this either. The principal repayment of the lease should be captured in depreciation (since the ROU asset is on balance sheet now) but no rationale for the interest component of the lease to be deducted from EBIT. It's a financing, not operational choice.
Previously, when operating lease expense was not counted in depreciation, you'd want to add back the interest component of that operating lease back to EBIT (because both the principal repayment AND the interest component were being counted as opex, so there was some interest expense in EBIT that shouldn't have been there).
Rerum odio repellendus veritatis. Iure fugiat est natus perferendis fuga quia iusto. Harum repudiandae odio dolor repudiandae.
Quae et id consectetur temporibus sunt et. Debitis voluptatibus autem nemo iure est. Illum quasi placeat earum non unde. Minima non ipsum quod magnam quidem.
Et accusamus qui laboriosam libero ad quia dicta. Quibusdam illo quia magni deserunt repudiandae. Quod suscipit itaque nesciunt iusto quasi.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...