“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 in his most recent shareholder letter concerning return on invested capital:
“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.”
Buffett is trying to tell us that companies reinvesting their retained earnings well will create great wealth for the investors coming along for the journey.
Return on invested capital is a fantastic metric to help us determine great capital allocators.
In this day of share repurchases, dividend increases, and the buying of companies, we must find a fantastic company allocating capital for its best use.
In today’s post, we are going to explore the following:
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.”
We can use ROIC to measure a company’s efficiency in allocating the profit it earns. We can also use it as a benchmark to compare to other companies in 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 it can generate on its reinvested cash.
- Said company should only retain earnings if they can create more value for the shareholders than what a shareholder could earn for themselves.
- Companies need to create returns above their return on capital that exceed their cost of capital.
Buffett refers to the stock price growth over time because the stock market recognizes the value of the company and the intrinsic value growing with realization.
Okay, now that we understand the return on invested capital and the impact on our businesses, let’s look at how to calculate the 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
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 company’s marginal tax rate.
- We use book values for the company as opposed to market values.
- We also need to consider the timing of financials; the capital invested comes from the end of the year, whereas the EBIT remains 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.
Okay, 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 is Microsoft. We will calculate based on the latest annual 10-K from June 30, 2022.
The first number we need to pull together is earnings before interest and taxes, or EBIT or its proxy, operating income.
Before proceeding, all numbers will be in millions unless otherwise stated.
Operating income or EBIT = $83,383 million
Next, we will need to calculate the tax rate for Microsoft, 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) = $10,978 million
Earnings Before Income Taxes = $83,716 million
Tax Rate % = $10,978 / $83,716
Tax Rate % = 13.11%
Okay, 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 )
We do the above calculation for the end of 2022 and 2021 using the 10-K’s for each year.
The book value of debt will require two numbers:
- Total debt & Capital Lease Obligation
- Minority Interest
We will look at Microsoft’s balance sheet to find the total debt.
For 2021 we add the numbers listed under liabilities.
- Current portion of long-term debt = $8,702 million
- Long-term debt = $50,074 million
- Operating lease liabilities = $9,629 million
Next, let’s find the minority interest of which Microsoft has none on its balance sheet.
From the shareholders’ equity section, we would see the line item listed as noncontrolling interest, which is the same as a minority interest.
Now let’s add up our debt.
2021 Total debt = $8,702 + $50,074 + $9,629 = $68,405 million
Now let’s do the same process for 2022.
2022 Book Value of Debt = $2,749 + $47,032 + $11,489 = $62,270 million
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.
2021 Book Value of Equity = $141,988 million
2022 Book Value of Equity = $166,542 million
The last two items will be cash and goodwill from the balance sheet.
2021 Cash & Equivalents = $130,334 million
2022 Cash & Equivalents = $104,757 million
Now that we have all of our numbers, we can calculate the Invested Capital for Microsoft for 2021 and 2022
Invested Capital 2021 = $68,405 + $141,988 – ($130,334) = $80,059
Invested Capital 2022 = $61,270 + $166,542 – $104,757 = $108,636
ROIC = NOPAT / ( Invested Capital 2022 + Invested Captial 2021)) / 2)
ROIC = $83,383 * (1 – 13.11%) / ( $80,059 + $108,636 ) / 2
ROIC $72,451 / $94,347
ROIC = 76.79%
At this point, let’s wait a moment before we analyze what our formula came up with before deciding if Microsofts’s ROIC is good or bad.
Okay, now that was pretty easy. Let’s look at another one to 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 2021.
First, let’s pull the numbers from the income statement for the earnings side of the equation.
Operating earnings = $25,942 million
Tax Rate = Income taxes / EBIT
Tax Rate = $4,756 / $18,696
Tax Rate = 25.4%
So the NOPAT will equal:
NOPAT = $25,842 * ( 1- 25.4%)
NOPAT = $19,278 million
Now let’s look at the Invested Capital section of the formula for 2021
- Total Debt = $63,640 million
- Minority Interest = $6,606 million
- Total Shareholders’ Equity = $87,531 million
- Cash = $17,741 million
Let’s calculate our 2019 Invested Capital.
2021 Invested Capital = $63,640 + $6,606 + $87,531 – $17,741 = $140,036 million
Now, let’s take a look at the Invested Capital for 2022
- Total Debt = $58,418 million
- Minority Interest = $8,638 million
- Total Shareholders’ Equity = $91,891 million
- Cash = $14,760 million
Let’s calculate our 2022 Invested Capital.
2022 Invested Capital = $58,418 + $8,638 + $91,891 – $14,760 = $144,187
Now that we have all the components, let’s figure out our ROIC for Walmart.
ROIC = $19,278 / ( $140,036 + $144,187)) / 2)
ROIC = $19,278 / $142,112
ROIC = 13.56%
I hope that makes sense, and you can work some return on invested capital calculations yourself.
What is a Good ROIC?
Now that we have figured out how to calculate a return on invested capital for a company we would like to buy, we need to analyze the results of our calculations and how we can determine if any company remains a good allocator of their capital.
We first need to compare the ROIC to its cost of capital. The cost of capital refers to the weighted cost of capital or WACC. Generally, we want a company with a higher return on invested capital than its cost of capital.
Why do we compare ROIC to the return on capital? Because it costs money to raise capital, and a company earning returns greater than the cost to raise capital earns excess returns. If a company continues to earn greater returns versus the cost of capital, its value will increase.
For example, as of today, Walmart’s cost of capital or WACC is 6.07%, and we calculated an ROIC of 13.76%, indicating Walmart earns returns above the cost of capital, which in turn indicates a reason why Walmart continues to thrive.
If we look at the calculations we did with Microsoft above, we can see the calculated ROIC of 76%, and when we compare it to the current WACC for the same period, we can see 7.34%, which gives us a tremendous rate of return above their costs of capital.
Do these numbers mean one company remains better than the other? Not even close, but the numbers can tell you to dig deeper to ensure each company you buy creates value for you.
In the case of Microsoft, 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 ROIC is it only looks at twelve months, which is far too short a time to evaluate a company.
Small sample sizes can skew results.
The other way to use ROIC as a comparison tool is to compare each company against other companies directly or to look at each industry’s benchmarks.
I will list a few of the more common industry ROICs. Then you could follow this link to a much more extensive chart outlining all ROICs across every potential return on invested capital, all courtesy of Professor Damodaran.
The chart is current as of January 2022, and Professor Damodaran updates the chart every year.
Benchmark ROICs of the most common sectors:
Bank (Money Center)
Brokerage & Investment Banking
The above chart shows a smattering of the ROICs across all sectors; for giggles, the total market ROIC as of January 2022 equals 8.61%, and without financials equals 10.58%.
To give you an idea of the power of ROIC, let’s look at the FANG stocks and see how they stand.
- Facebook (FB) = 31.93%
- Apple (AAPL) = 33.75 %
- Netflix (NFLX) = 12.63%
- Google (GOOG) = 35.17%
To put our comparisons to the test, let’s look at the companies we calculated and see how they might stack up compared to their competition.
- Walmart = 13.56%
- Target = 13.24%
- Amazon = 5.84%
It would appear that Walmart is carrying an ROIC higher than the level of its competition.
Return on invested capital offers us another tool to add to our toolbox that can help us determine a company’s profitability, as well as determine its ability to generate more profits from its reinvested capital.
More Warren Buffett on return on invested capital and its 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 comes from his 1987 Shareholder letter, which illustrates the thought that he brought to light a topic not much discussed among CEOs; therefore, and not discussed among investors.
Using ROIC to find a company that will build value for us, the shareholder, offers us another tool to determine shareholder-friendly companies.
Well, that will wrap up our discussion on return on invested capital.
Thank you for taking the time to read this post, and I hope you find something valuable to use in your investing journey.
If I can be of any further assistance, please don’t hesitate to reach out.