Reader’s Questions: ROIC

Return on Invested Capital: ROIC

A reader asked about calculating ROIC:

http://www.scribd.com/doc/82818728/ROIC

There is no perfect way to determine ROIC.

1.  Do you use net PPE or Gross PPE?

2.  What happens when you ignore goodwill in your calculation?

3.  How do you calculate excess cash?

4.  Do you adjust the way you calculate ROIC depending upon the type of industry?

5.  What is more important a 100% ROIC vs. a 200% ROIC or being able to redeploy that capital at high rates?

I will write-up my response but read the PDF from Bear Stearns on ROIC to think about the subject.

7 responses to “Reader’s Questions: ROIC

  1. Some good material to digest here – thanks John. I’d add one more question to the set above: while I understand theoretically the exclusion of (excess) cash when computing Invested Capital since it doesn’t play a part in generating the NOPAT, I myself leave it in in order to automatically penalize (lower the ratio of) companies who hold on to cash but don’t actually do anything with it. Does this make sense for a non-activist investor, who is trying to gauge the value of the core business ALONG WITH the current management who runs it, or should we focus on core business value alone?

    • Well, what Joel G does (as he described in his lectures) is to separate out excess cash from the operating business, but then discount the value of that cash depending upon your assessment of management’s integrity, ability and past record. I think his approach is sound.

  2. a 100% ROIC capital business that can redeploy capital at 100% ROIC is a lot better than a 200% ROIC that can only return capital to shareholder (or worse).

  3. I’m quite sceptical of many ROIC calculations, esp. Greenblatt. There are lots of arguments, and counter-arguments for using his approach.

    For one thing, the ROIC values generated seem unmeaningfully high. 100% ROIC, for real?

    I think the whole idea behind Greenblatt’s ROIC is that he’s trying to calculate a return on new incremental captial employed. The problem is, what is that really? I’m pretty sure it’s not going to be 100%.

    The brings me around to goodwill. Greenblatt excludes goodwill. For sure, it is “just” a “bookkeeping artifact”, but on the other hand, it really was expended in obtaining the results that the company sees today. If the company didn’t have to pay over the odds to acquire assets, then why did it? And what makes you think that it wont need to expend similar amounts in boosting earnings in future?

    If you’re looking for “good” companies, then I don’t think there’s too much wrong with looking for high ROE companies that have minimum debt. After all, as Warren Buffett says, good companies shouldn’t need to employ a lot of debt. So you’ve “solved” the problem of debt distorting ROEs simply by insisting on modest debt levels.

    • Dear Mcturra:

      All salient points which I hope to address within the next day with a third (final) post on ROIC.

      Then I will circle back to your points. Yes, for certain companies you would be foolish to ignore goodwill.
      Also ROE and ROIC have the same issues with GAAP accounting.

  4. John – could I request that you also address computation of WACC in order to determine excess returns? Cost of debt is easy enough to estimate from the I/S and B/S, but cost of equity is different. A finance professor would tell me to use CAPM but what would a real business owner or CFO use?

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