ROICing the Market

Tuesday’s Moneybox introduced–not to the world, just to this column–the idea that a company’s return on invested capital (ROIC) was a much superior way of measuring its economic performance than earnings growth or sales growth or, well, anything else, really. But even as I sang the praises of ROIC, I failed to tell you exactly how to figure out what a company’s ROIC is. So here’s the answer to that problem. It’s esoteric, but I promise it’s worth it, at least if you’re interested in seeing why the performance of companies like Dell and Coke is so relatively remarkable.

In essence, what ROIC looks to capture is the amount of cash generated by the company’s ongoing operations relative to the capital needed to generate that cash. As a result, return on invested capital is simply the company’s net operating profit after tax (NOPAT) divided by its invested capital. NOPAT is equal simply to sales minus operating expenses minus taxes. (Keep out interest earnings or one-time deals from the sales number.)

To find “invested capital,” just take a company’s assets, subtract its current liabilities, then subtract the cash it has on the balance sheet. This is the amount of money the company has spent on working assets less the normal cash that flows in and out. (To figure out a company’s ROIC for a given period, you need to calculate these numbers at the beginning of the period and at the end, and average them.) A company like Dell has few assets–relative to its sales–and high liabilities, since it waits to pay its suppliers until after it gets paid by its customers. As a result, its return on invested capital is astronomical. This is a good thing if you’re a Dell shareholder.

There are, of course, other ways of calculating ROIC. Some people think you shouldn’t subtract cash at all, since it is being “invested” even if it’s not being put to work in the business. Others think you should subtract “excess cash”–say, cash in excess of 20 percent of revenues–from total assets. And there are also modifications you can make to NOPAT involving uniform tax rates and the like, modifications that you should worry about only if your parents cruelly blocked you from your dream of being an accountant.

Regardless of the method, the basic equation is what matters. One other thing to keep in mind is that, strictly speaking, a company’s ROIC should be measured against its “cost of capital.” A good rule of thumb is that it costs a company 10 percent to raise capital for its operations (whether by borrowing or issuing equity). If a company’s ROIC is less than its cost of capital, it’s actually destroying value. This is the case, for example, with most Hollywood studios in any given year. Here’s a fun exercise: calculate Dell’s ROIC and compare it to that of, say, MGM. It’s like comparing Mark McGwire’s numbers to those of feeble Mets’ shortstop Rey Ordonez.

By the way, although most investors don’t know about ROIC, most corporations do. Dell, for instance, bases its entire bonus scheme around ROIC. The market may not know exactly why Dell is so impressive, but Dell does.