Metric analysis

1 metric all investors should consider before buying a new stock

In 1999, Barrons published an article titled “Amazon.bomb”, which predicted the imminent demise of the e-commerce company. The author of the article quoted several times Amazon‘s lack of profitability as an indication that the company was poorly managed and heavily overvalued.

Hindsight being 20/20, it’s obvious Barrons got the quality of Amazon’s management team wrong. And yet, 23 years later, we find ourselves in a similar environment, with skeptics making familiar claims about less profitable growth companies.

To be fair to the critics, stocks have become very overvalued over the past two years. But history has shown us that you can’t rely on a single valuation metric like the price-to-earnings (P/E) ratio to judge the quality of a company.

A lesser-used metric that gives investors a contextual view of the effectiveness of a company’s management team is known as return on invested capital (ROIC).

Image source: Getty Images.

What is ROIC?

ROIC is a measure of how effectively a company’s management team generates a return on the capital it deploys. And it’s one of the most important valuation tools for investors to understand.

As an early investor, I’ve heard statements like “buy quality companies and let them accumulate” countless times. Although it sounds simple, the definition of quality is broad and subjective, depending on who you talk to.

This is why I love ROIC. It’s not subjective; it is a quantitative measure of how a company allocates its cash.

Calculation of return on investment

Calculating ROIC is a bit more complicated than other metrics like the P/E ratio. But bear with me – it’s not that scary.

The ROIC formula is:

Net operating profit after tax (NOPAT)/invested capital (IC)

Before you can calculate the ROIC, you must first generate values ​​for the numerator and denominator.

NOPAT represents the profits a company would make if it had no debt. To calculate it, simply multiply the company’s operating profit by 1 minus the tax rate.

Operating profit can be found on the income statement, and the tax rate can be easily obtained by dividing pre-tax profit by tax expense (both of which can also be found on the income statement). Here is the formula for NOPAT:

NOPAT = operating profit (tax rate 1)

From there you will need to calculate the numerator in our formula ROIC – invested capital. To get this number, go to the liabilities section of the balance sheet and add together the long-term (or non-current) and short-term (current) debt, called total debt. Subtract cash and cash equivalents from total debt to arrive at net debt.

The final step in calculating invested capital is to add total balance sheet equity to the net debt you just generated. And now you have your ROIC denominator. Here is the formula:

Invested capital = net debt + total equity

Now that you have both your numerator and denominator, simply divide NOPAT by invested capital and you will arrive at the company’s ROIC. Return on investment varies by industry, so it’s important to compare a company’s return on capital to that of its competitors in the same space. But generally speaking, an ROI above 20% is high, and an increasing ROI indicates a business that is improving over time.

Real example of ROIC

Here is an example using Apples 2021 review:

NOPAT is calculated by multiplying operating profit, $109 billion, by 1 minus the tax rate. Apple’s tax rate is 13% or 0.13, so to calculate Apple’s NOPAT, we simply multiply $109 billion by 0.87, which equals $95 billion.

Next, we need Apple’s invested capital, which is its net debt, $84 billion, + its total equity, $63 billion, which equals $147 billion.

Finally, to produce the current ROIC, simply divide Apple’s NOPAT by its invested capital:

$95 billion (NOPAT) / $147 billion (invested capital) = 64% (ROIC)

This number alone gives us a glimpse of how incredibly efficient Apple is in 2021 in getting a return on the money it has invested in its business.

But if we extend the calculation several years back, we get a better look at how the company’s ROIC has changed over time:

Year

ROIC

2017

21%

2018

32%

2019

37%

2020

42%

2021

64%

Data source: Apple 10K.

Here we see that not only is Apple generating a very high return on investment from 2021, but it has also steadily increased its return on investment over the past five years.

There are various other methods of calculating ROIC that may produce slightly different percentages, but the most important thing is to look at the trend of ROIC over time. You should look for companies that are becoming more capital efficient (i.e. increasing their return on investment year over year), not less.

An important tool to add to your repertoire

ROIC is certainly not a substitute for other metrics and analysis, but it is a very effective tool for determining the quality of the management team and the overall trajectory to higher profitability.

Earnings growth alone tells investors nothing about the amount of capital the company had to invest in the business to achieve that growth rate. By looking at return on investment, we can see if a company is getting an increasingly higher rate of return on its investments or if it is slowly burning more capital to maintain a high rate of growth. The latter should be a big red flag for investors.