Return on invested capital (ROIC) is one tool that value investors use to determine whether or not a company has a sustainable advantage over its competitors. Some investors call this sustainable competitive advantage a “moat”. Companies with a moat tend to dominate industry niches in which they operate, and the stock market tends to reward investors in these companies with higher stock prices as they grow within their market niche.
Return on Invested Capital (ROIC) = Net Operating Profit After Taxes (NOPAT) / Invested Capital Return on invested capital is a good way to screen for companies that may have a moat, because it measures how efficiently a company uses its available money to create the profit it generates. If a company has a large return on the capital it invests, especially when compared to its competitors, it is probably because the company has a more efficient way of producing its goods or services, or it can charge prices that allow it to earn more profit margin than its competitors.
Here are 4 reasons that make return on invested capital an indicator you should use to screen for companies that may continue to achieve above average growth:
1) Management efficiency – ROIC shows how well a management team generates operating profits vs. the amount of money they use to generate those gains
2) Clarifies the Income Statement – Instead of just focusing on net income (the “E” in the P/E ratio), ROIC uses NOPAT instead, which removes items like investment income and interest expense (among others), which gives a much clearer picture of how much profit the company is actually generating as a result of its profit making operations
3) By using investment capital instead of just equity or assets (like return on equity (ROE) or return on assets (ROA)), return on investment capital uses deployed equity AND debt capital, and removes cash that is just sitting in a bank account collecting interest instead of generating returns via the company’s operations
4) Companies with a high return on invested capital within their industry are generally leaders, or emerging leaders, within their market niche.
By using the ROIC formula shown above, you can prove what this article states with a quick visit to MSN money, and comparing the historic return on invested capital rankings of Google and Yahoo (you probably used one of these search engines to find this article). As you see the ROIC values for these two companies, and look at their relative stock price performance, you may find the results enlightening.