Return in Invested Capital (ROIC)

• ROE is a important indicators of a firm’s profitability and potential growth
• There are some pitfalls of using ROE for measuremen - ROE can be increased with debt. 
• ROIC corrects ROE's problem - looks at all moneys (by shareholder and lender) invested into company and how much profit the management can generate.
• It is arguably the best way to determine if a company has a moat.
• Investor focused on earnings growth and not ROIC would miss the fact that the earning growth was generated by how much capital (include debt).
• It is very useful as comparisons among companies within sectors. Highest ROIC = making more profits from every dollar invested - often show the biggest share price gain (shown by Joel Greenblatt's Magic Formula)
• Formula
• ROIC = NOPAT / Invested Capital 
• NOPAT = Net Operating Profit After Tax = Operating Income * (1 – Tax Rate)
• !!! Operating Profit (aka EBIT) -  not include items such as investments in other firms, taxes, interest expenses and other nonrecurring items  
• Invested Capital = Total equity and equity equivalent + total debt – excess cash and investments
• Excess cash  -  cash of a company has that is not required to operate the business. (1) interest income is not part of Operating Income (2) if company with significant cash balance - the divided result might yield too low
• or, we take the total asset and minus out non interest bearing liabilities
  Invested Capital =  Total Asset - Non Interest bearing current liabilities - Excess Cash
• =Fixed Assets + Current Assets – Non-interest bearing Current Liabilities – Excess Cash
• = Fixed Assets + Non-cash Working Capital
•  Non Interest bearing current liabilities  -  account payable (it is capital invested in the business by a company’s suppliers or contractors, not the company itself), deffered revenue and deffered tax.
• Long term investment - it is not operating assets and should be excluded
•  Use of ROIC
• If company ROIC > 15% for number of years - it most likely has a moat.
• But a positive spread between ROIC and WACC alone doesn't justify an economic moat. Investors also have to think about the qualitative attributes--high barriers to entry, huge market share, low-cost production, corporate culture, patents, or high customer switching costs--that create an economic moat around a company's profits. 
• Compare the efficiencies of companies using ROIC in the same industry to determine which is a better one to invest in. 
• ROIC can also be compared to the firm’s cost of capital to conclude whether the firm has collectively invested in good projects. - A company creates value only if its ROIC is higher than itsWACC.
• Cost of Capital
• When company raise capital from owners or lenders, the investor require a return on their investment.
• Stable and predictable company will have a low cost of capital, while a risky company with unpredictable cash flows will have a higher cost of capital.
• Weighted average cost of capital (WACC) - all capital sources - common stock, preferred stock if any, bonds and any other debt - are included the calculation.  
• WACC = E/V * Re + D/V * Rd * (1 -Tc)
• E = Market Value of Equity
• D = Market \ Book Value of Debt
• V = Total Value of Firm = E + D
• Re = Required return of equity holders
• Rd = Required return of debt holders
• Tc = Tax rate (cost of debt is tax deductible)

References:-

• Return On Invested Capital kcchongnz (private)
• Five Cheap Companies that Create Value, Harness the power of high returns on invested capital by Elizabeth Collins
• ROIC-Greenblatt-and-Fool-Articles

Comparing companies with ROIC: A case for Pintaras Jaya kcchongnz

Author: kcchongnz   |   Publish date: Sat, 12 Apr 17:24

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Comparing companies with ROIC: A case for Pintaras Jaya kcchongnz
"The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine."
-- Warren Buffett


In my previous post  below, I used the return on equity (ROE) to compare the performance of two companies in the similar industry, Pintaras and Kimlun. We found that Pintaras at a ROE of 19.4%, it is far better than the 12.1% of Kimlun.
http://klse.i3investor.com/blogs/kcchongnz/49969.jsp
ROE is an easy-to-calculate and a good tool that helps to measure a company's ability to earn returns on shareholder capital, if it is consistently high, and how is it when compare with its peers. It is especially useful to compare financial service firms, such as banks and insurance companies. I have in fact use ROE to value their stocks based on the following formula:
Fair value of stock = ROE/Required return * Book value
ROE has proven enduring. At one level, this makes sense. ROE focuses on return to the shareholders of the company. If you are a shareholder, this gives you a quick and easy to understand metric.
But ROE can obscure a lot of potential problems. Companies can resort to borrowing more money to artificially maintain a high ROE — for a while — and hide deteriorating performance in business fundamentals. At the same time, it can subject the company to the risk of bankruptcy during a financial crisis. Excessive leverage, or borrowing too much can cut both ways. Hence I often advocate the use of another metric, return on invested capital (ROIC) as a measure and comparison of efficiency.
What is ROIC?
ROIC looks at all the money invested into the company, both by shareholders and lenders, to measure how well management uses all that cash to generate profits. It is calculated as net operating profits after taxes (NOPAT) divided by invested capital.
ROIC = NOPAT / IC
NOPAT = Earnings Before Interest & Taxes (Ebit) * (1 - Tax Rate)
IC = Net operating working capital + Property, plant and equipment
We need to measure ROIC against weighted average cost of capital (WACC) since WACC is the minimum rate of return that a firm needs to earn for its stakeholders.

Re = cost of equity
Rd= cost of debt
E= Market value of equity
D= Market (or book) value of debt
V = E + D
Tc = corporate tax rate
One thing to look for is that when ROIC is greater than WACC, value is being created for the stakeholders.  When this ratio is less than WACC, value is being destroyed.  On very broad terms, a firm with a higher spread between ROIC and WACC tends to be more valuable than a firm with a lower spread.

Pintaras Jaya and its ROIC
The following Table 1 shows the computation of ROIC of Pintaras for its trailing twelve month results for 2014, and its comparison with Kimlun.
Table 1:

Comparison of ROIC	Pintaras	Kimlun
Ebit (in thousands)	70,886	49610
Tax rate	21.8%	5.1%
NOPAT	55438	47080
Net working capital	83237	118709
PPL	73942	157599
IC	157179	276308
ROIC=NOPAT/IC	35%	17%

The computation shows that the ROIC of Pintaras is 35%, more than three times its WACC, which is the required return of equity shareholders, as it has zero debt. My required return in investing in Pintaras is 10%, a relatively lower value as it has stable earnings and cash flows. How is it compared to its peer, Kimlun?
Kimlun has a market capitalization of RM414m at RM1.72 at the close on 11^th April 2014. It has a total debt of RM235m in book value. Hence its WACC is 9.0%, assuming cost of equity at 12%, cost of debt 5%, and a tax shield of 25%.
Hence ROIC of Kimlun is still good at 17% as it is way above its WACC. It can be said that Kimlun has cleverly utilize debts to enhance its return of capital. It is just a little risky with the debt about 0.8 times its equity, especially when the economy turns for the worse, or a looming financial crisis. However, when compared with Pintaras, its ROIC is far behind.
It is clear that Pintaras financial performance is far better than Kimlun, both measured in ROE and ROIC. However, we still have to determine the price we have to pay in order to decide which company is a better investment.

K C Chong (12^th April 2014)