Financial Ratio| Return on Invested Capital (ROIC)

Regarding the financial ratio, ROIC, I think this article is quite knowledgeable and informative to share with the readers to improve the related knowledge altogether.

Extract

The best long-term investments tend to be companies that can reinvest over and over again at high rates of return.  Those high rates of return attract competitors so you must also understand barriers-to-entry.  But first study how to calculate incremental returns on capital or marginal returns on invested capital (“MROIC”).   

Φ One quick and dirty way is to look at the amount of capital the business has added over a period of time, and compare that to the amount of incremental growth of earnings. Last year Walmart earned $14.7 billion of net income on roughly $125 billion debt and equity capital, or just under 12% return on capital. Not bad, but what we really want to know if we are going to buy Walmart is: 

a) how much of their earnings will they retain and reinvest in the business going forward? and 

b) what will the return on that reinvested capital be?Φ 10 years ago in fiscal 2006, Walmart earned $11.2 billion on roughly $83 billion of capital, or around 13.5%. But in the subsequent 10 years, they invested roughly $42 billion of additional debt and equity capital ($125b invested in 2016 and $83b invested in 2006), and using that incremental $42 billion they were able to grow earnings by about $3.5 billion (earnings grew from $11.2 billion in 2006 to around $14.7 billion in 2016). So in the past 10 years, Walmart has seen a rather mediocre return on the capital that it has invested during that time (roughly 8%).

Φ We can also look at the last 10 years and see that Walmart has retained roughly 35% of its earnings to reinvest back in the business (the balance has been primarily used for buybacks and dividends).

Φ As I’ve mentioned before, a company will see its intrinsic value will compound at a rate that roughly equals the product of its ROIC and its reinvestment rate. So if Walmart can retain 35% of its capital and reinvest that capital at an 8% return, we’d expect a modest growth of intrinsic value of around 3% per year (35% x 8% = 2.8% per year).

Φ This is a really rough measure, and this back of the envelope method works okay with a large, mature company like Walmart.

Φ But what you really want to know is what will the business retain going forward and what will the return be on the capital it retains and reinvests? Of course, there are different ways to measure returns (you might use operating income, net income, free cash flow, etc…) and there are many ways to measure the capital that is employed.