“A truly great business must have an enduring “moat” that protects excellent returns on invested capital.”
–Warren Buffett, 2007 Shareholder Letter
Another quote from Buffett and his most recent shareholder letter concerning return on invested capital (ROIC):
“Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back into the business. Thus there is an element of compound interest (Keynes’ italics) operating in favour of a sound industrial investment. Over a period of years, the real value of the property of a sound industrial is increasing at compound interest, quite apart from the dividends paid out to the shareholders.”
What I think Buffett is trying to tell us here is that companies that reinvest their retained earnings well will create great wealth for the investors that come along for the journey.
Return on invested capital is a fantastic metric to use to help us determine great capital allocators.
In this day of share repurchases, dividend increases, and the buying of companies, we must find a company that is fantastic at allocating that capital for its best use.
In today’s post, we are going to explore:
- What Return on Invested Capital Is (ROIC)
- How do we calculate ROIC
- What is a good ROIC?
What is Return on Invested Capital (ROIC)?
According to Investopedia:
“Return on invested capital (ROIC) is a calculation used to assess a company’s efficiency at allocating the capital under its control to profitable investments. The return on invested capital ratio gives a sense of how well a company is using its money to generate returns. Comparing a company’s return on invested capital with its weighted average cost of capital (WACC) reveals whether invested capital is being used effectively.”
You can see that ROIC is used to measure a company’s efficiency at allocating the profit it earns; it also is used as a benchmark to compare other companies in like industries, such as tech, banking, retail, and so on.
I am going to refer to Buffett again, his common-sense approach to finance is much easier to understand, I think.
“Unrestricted earnings should be retained only when there is a reasonable prospect – backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.”
Buffett is saying a few things here:
- A company’s value creation comes from the returns a company can generate on its reinvested cash.
- Said company should only retain earnings if they can create more value for the shareholders, as opposed to what a shareholder could earn for themselves.
- Company’s need to create returns above their return on capital that exceed their cost of capital.
What Buffett is referring to is the stock price over time growing because the stock market recognizes the value of the company and the intrinsic value growing with that realization.
Ok, now that we understand what return on invested capital is and how it can affect our businesses, let’s take a look at how to calculate this ratio.
How do we Calculate ROIC?
The formula for return on invested capital measures how well a company generates cash flow compared to the capital it has invested in the business.
Here is the formula, and we will break it down.
Return on Invested Capital = NOPAT / Average Invested Capital
Let’s break this down a bit, shall we?
There are four components to ROIC
- We use operating income or EBIT, earnings before income taxes instead of net income.
- We adjust the operating income or EBIT by the marginal tax rate of the company.
- We use book values for the company as opposed to market values.
- The final is timing; the capital invested is from the end of the year, whereas the EBIT is the current value, i.e., by quarter or annual data.
A final note before we dive in, NOPAT stands for Net Operating Profit After Tax, for those who were curious.
Ok, now that we know the formula, let’s start to find the numbers to plug into our formula.
The first company I would like to explore will be none other than Berkshire Hathaway (BRK.B). Might as well look at the masters’ performance first. We will do this calculation based on the latest annual 10-k, from December 2018.
The first number we need to pull together is earnings before interest and taxes, or EBIT. To do this, we look at the line item that says earnings before income taxes, which equals $4,001. Next, we will add the interest expense from above of $3,853.
A note before we proceed, all numbers will be in millions unless otherwise stated.
EBIT = $4,001 + $3,853
EBIT = $7,854
Next, we will need to calculate the tax rate for Berkshire, or you could go to your favorite website and find it, I use gurufocus.com as my go-to.
To find the effective tax rate, we use the following formula.
Tax Rate % = Tax Expense / Pre-tax Income
So if we go back to our income statement we can find our numbers, I will highlight them for you.
Let’s calculate our effective tax rate from the above numbers.
Income Tax Expense (Benefit) = -$321
Earnings Before Income Taxes = $4,001
Tax Rate % = -$321 / $4,001
Tax Rate % = -8.02%
Ok, now we need to determine our average invested capital. The formula for this will be:
Invested capital = Book value of debt + Book value of equity – ( Cash & Cash equivalents + Goodwill )
We do the above calculation for both the end of years for 2017 and 2018 using the 10-ks for each year.
The book value of debt will require two numbers:
- Total debt & Capital Lease Obligation
- Minority Interest
To find the total debt, we will look to the balance sheet for Berkshire.
For 2017 we add the numbers listed under liabilities for notes payable insurance and railroads; Berkshire breaks up their balance sheet to show the performance of the different sectors of their business.
2017 Total debt = $62,178 + $40,419
2017 Total debt = $102,597
Next, let’s find the minority interest.
From the shareholders’ equity section, we can see the line item listed as noncontrolling interest, which is the same as a minority interest.
We will add this number to our total debt to get the book value of our debt.
2017 Total debt = $102,597 + $3,658
2017 Book Value of Debt = $106,255
Now let’s do the same process for 2018.
2018 Book Value of Debt = $62,515 + $34,975 + $3,797
2018 Book Value of Debt = $101,287
The next item we need is the book value of the equity, which will be the total shareholders’ equity listed on the balance sheet under the shareholders’ equity section.
2017 Book Value of Equity = $348,296
2018 Book Value of Equity = $348,703
The last two items will be cash and goodwill, also from the balance sheet.
2017 Cash = $28,673 + $56,478 + $2,910 + $24,780
2017 Cash = $112,931
2018 Cash = $27,749 + $56,323 + $2,612 + $24,702
2018 Cash = $111,386
Now that we have all of our numbers we can calculate the Invested Capital for Berkshire Hathaway for 2017 and 2018:
Invested Capital 2017 = $106,255 + $3,658 + $348,296 – $112,931
Invested Capital 2017 = $345,278
Invested Capital 2018 = $97,560 + $3,727 + $348,703 = $111,386
Invested Capital 2018 = $338,604
ROIC = NOPAT / ( Invested Capital 2018 + Invested Captial 2017)) / 2)
ROIC = 7854 * (1 – -8.02%) / ( 345278 + 338604 ) / 2
ROIC = 8498 / 341941
ROIC = 2.48%
At this point, let’s wait a moment before we analyze what our formula came up with before deciding if Berkshire’s ROIC is good or bad.
Ok, now that was pretty easy, wasn’t it? Let’s take a look at another one, so we are sure we understand what we are calculating.
The next one I would like to take a stab at is Walmart, we will use their latest 10-k as well, from January 2019.
First, let’s pull the numbers from the income statement for the earnings side of the equation.
Operating earnings = $21,957
Tax Rate = Income taxes / EBIT
Tax Rate = $4,281 / $11,460
Tax Rate = 37.3%
So the NOPAT will equal:
NOPAT = $21,957 * ( 1-37.3%)
NOPAT = $13,676
Now let’s look at the Invested Capital section of the formula for 2019
- 2019 Total Debt = $58,033
- 2019 Minority Interest = $7,138
- 2019 Total Shareholders’ Equity = $72,496
- 2019 Cash = $7,722
Let’s calculate our 2019 Invested Capital.
2019 Invested Capital = $58,033 + $7,138 + $72,496 – $7,722
2019 Invested Capital = $129,945
Now, let’s take a look at the Invested Capital for 2018
- 2018 Total Debt = $46,487
- 2018 Minority Interest = $2,953
- 2018 Total Shareholders’ Equity = $77,869
- 2018 Cash = $6,756
Let’s calculate our 2018 Invested Capital.
2018 Invested Capital = $46,487 + $2,953 + $77,869 – $6,756
2018 Invested Capital = $120,553
Now that we have all the components together let’s figure out our ROIC for Walmart.
ROIC = $13,676 / ( $120,553 + $129,945)) / 2)
ROIC = $13,676 / $125,249
ROIC = 10.91%
Ok, hope that makes sense, and you can work some return on invested capital calculations yourself.
What is a Good Return on Invested Capital?
Now that we have figured out how to calculate a return on invested capital for a company we would like to buy. Now would be the time to discuss the results of our calculations and how we can determine if any company is a good allocator of their capital.
The first comparison would be to compare the ROIC to its cost of capital. The cost of capital refers to the weighted cost of capital or WACC. Generally, you are looking for a company that has a higher return on invested capital than its cost of capital.
Why are we comparing it to the return on capital? Because it costs money to raise capital and a company that is earning returns greater than the cost to raise capital is earning excess returns. If a company continues to earn greater returns versus the cost of capital, then that company will see its value increase.
For example, as of today, Walmart’s cost of capital or WACC is 4.79%, and our calculated ROIC was 10.91%. That indicates that Walmart is earning returns above the cost of capital, which is one of the reasons why Walmart continues to thrive.
If we look at the calculations we did with Berkshire Hathaway above, we can see that the ROIC we calculated was 2.48%, and when we compare that to the current WACC for the same period, we can see 7.34%. This would indicate that Berkshire had a rough year in comparison to their ability to generate returns above its cost of capital.
Do these numbers mean that one company is better than the other? Not even close, but what it can tell you is to dig deeper to make sure that each company you buy is creating value for you.
Berkshire, for example, has had a rough few years with the new accounting rules, which mandates that they include their gain/losses from their investments. Both Charlie and Warren disagree with this rule, but they follow the law.
In the case of Berkshire, I would recommend looking at their ROIC over a longer time versus their cost of capital to give you a better idea of their performance. One of the flaws of this formula is that it is only looking at twelve months, and that is far too short a time to evaluate a company.
A small sample size can skew results.
The other way to use ROIC as a comparison tool is to compare each company against either other companies directly or to look at each industry’s benchmarks.
I am going to list a few of the more common industry ROICs, and then you could follow this link to a much more extensive chart outlining all ROIC across every conceivable return on invested capital, all courtesy of Professor Damodaran.
The chart is current as of January 2020, and Professor Damodaran updates the chart every year.
Benchmark ROICs of the most common sectors:
- Bank ( Money Center ) -0.03%
- Bank ( Regional ) -0.06%
- Beverage ( Alcohol ) 14.95%
- Beverage ( Soft ) 26.21%
- Brokerage & Investment Banking 0.04%
- Computer Services 24.89%
- Drugs ( Biotech ) 8.64%
- Drugs ( Pharma ) 18.29%
- Financial Services ( Ins ) 0.23%
- Healthcare Products 15.87%
- Oil/Gas ( Production ) 9.03%
- REIT 2.92%
- Retail Online 9.99%
- Software 20.03%
That is just a smattering of the ROICs across all sectors, for giggles the total markets ROIC as of January 2020 is 7.31%, without financials is 12.96%.
To give you an idea of the power of ROIC, let’s look at the FANG stocks and see how they stand.
- Facebook (FB) 35.24%
- Apple (AAPL) 42.43%
- Netflix (NFLX) 16.19%
- Google (GOOG) 36.58%
To put our comparisons to the test, let’s look at the companies we calculated and see how they might stack up compared to its competition.
- Walmart 10.91%
- Target 14.35%
- Amazon 22.84%
It would appear that Walmart is carrying an ROIC that is not to the level of its competition.
Next, let’s look at Berkshire.
- Berkshire Hathaway 2.49%
- Met 12.01%
- Prudential 9.69%
Again, it just illustrates how Berkshire had a tough year in 2018, but I would never bet against Warren Buffett, and I would guess that 2019 and beyond will be much improved. I base this on looking back at their historical numbers, which are much higher.
Return on invested capital is another tool to add to our toolbox that can help us determine the profitablilty of a company, as well as determine that company’s ability to generate more profits from its reinvested capital.
More Warren Buffett on return on invested capital and it’s importance:
“The heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising because most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration, or, sometimes, institutional politics.”
The above comment is from his 1987 Shareholder letter, and it illustrates the thought that he brought to light that ROIC is not talked about among CEOs; therefore, it is not discussed among investors either.
Using ROIC to find a company that will build value for us, the shareholder is another tool we can use to determine which companies are shareholder-friendly or are not.
Well, that is going to wrap up our discussion on return on invested capital.
I want to thank you for taking the time to read this post, and I hope that you find something valuable to use on your investing journey.
As always, if I can be of any further assistance, please don’t hesitate to reach out.