Plenty of folks love to speculate by buying the hottest, trendiest stocks that garner the most headlines. Buying the same stocks as your friends can give you comfort that you’re doing the right thing. Seeing that a hot stock has doubled may compel you to buy it before it doubles again. Unfortunately, this kind of speculation does not typically end well. Savvier investors don’t want to risk their money to the luck of the draw. One form of homework these savvy investors use is fundamental analysis. One prevalent metric used in fundamental analysis is Return on Invested Capital.
These investors know that, in the long-term, a stock’s price is a function of the company behind it. These folks typically do their homework before risking their money on a stock. They want to know about the company and how much its shares are worth as much as possible. This approach to trading is called investing.
Return on Invested Capital
When investors use metrics when performing their fundamental analysis and return on invested capital, they’re using short mathematical formulas to answer specific questions about the company. Those questions might include, how profitable is the company? Does the company make enough money to manage its debt? Is the company successful in managing its working capital?
Every company uses money (capital) to start the business, expand the business, or complete projects. Capital usually comes in the form of debt or equity. If a company’s managers borrow money to raise capital, they will own the creditor interest and principal. If the managers use equity, they sell part of the company to a new owner who expects to collect a portion of its profits.
As you can see, managers need to use capital in the most efficient manner possible. Say a company raises money to fund a project that they expect to increase its profits. If the project is unsuccessful and the company does not increase profits, it is in trouble. It is in trouble because it owes more money to the capital providers but fails to increase profits.
Of course, the opposite is true. If the company can raise capital to fund projects that increase profits by more than the cost of new capital, then the company will have increased profits beyond the additional cost of capital.
Keep reading to learn more about return on invested capital.
Return on Invested Capital Formula
Metrics like return on invested capital (ROIC) usually have easy-to-use formulas. Fundamental analysts can find the inputs used in each metric on the financial statements. Because ROIC determines how well a company uses its capital to improve profit, the formula uses profit in the numerator and capital in the denominator.
The formula looks like this:
ROIC = NOPAT/Invested Capital
In the formula, NOPAT is an acronym that stands for Net Operating Profit After Tax. In other words, it is the profit of a project, expansion, or the entire company. Invested capital is the capital raised for the project, expansion, or the whole company. Invested capital is usually debt, equity, or a combination.
ROIC is expressed in percentage terms and shows how successful a company improves its after-tax profits compared to the capital that it raises. The higher the ROIC, the better.
Let’s run through an example. Say a company borrows $1,000,000 of capital from a bank to start the business. In its first year, it earns $100,000 in after-tax profits. After the first year, its ROIC is 10%: 10% = $100,000/$1,000,000.
Before the second year, the company buys new software that it predicts will increase after-tax profit by $20,000. The software will cost $30,000. So, the company borrows $30,000 of capital for the software, and their profit estimates are correct. The after-tax profits after the second-year increase to $120,000 and invested capital increases to $1,030,000, and return on invested capital increases to 11.65%: 11.65% = $120,000 / $1,030,000.
High ROIC Stocks
Like the previous example, high return on invested capital stocks have managers who can use capital to increase the company’s profits. Of course, the opposite is true also. Managers who use capital poorly can destroy value by failing to invest capital profitably. In addition to using ROIC to find great investments, investors can avoid risky stocks.
Investors using the ROIC metric to find stocks rely less on luck and more on skill. In the long run, doing a little fundamental analysis to find high ROIC stocks for your portfolio will likely put you in a better position than buying the latest hot stocks.