The importance of return on invested capital and compounding
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Return on invested capital, or ROIC for short, is just one of the many return on capital (ROC) metrics investors can use to determine the long-term future performance of a company. A high return on invested capital can be thought of as an 'engine' that drives company growth - as every pound of profit can be reinvested at this high rate of return. Indeed, ROIC has featured heavily in the writings of Warren Buffett, Joel Greenblatt, and even Ben Graham, to name a few. But there are, in reality, few companies that are able to achieve a strong, recurring ROIC, as a percentage of the overall stock universe.
Screening 8,351 of the world's largest stocks by market capitalization reveals that only 5,175, roughly 62%, have achieved an average ROIC of at least 3.1% over the past five years (similar to the average yield on the U.S. ten-year treasury over the same period). 35% of the group achieved a return of greater than 10% and only 13% managed to achieve an average ROIC of 25%, or greater, per annum over the past five years. The companies that make this top bracket are the likes of Philip Morris, Microsoft, GlaxoSmithKline and Roche, all of which have strong competitive advantages.
You may think that a ROIC of 25% is excessive. However, a lower figure is simply not going to compound owners' value at attractive rates. Over the past nine decades, the average annual return from stocks has been around 7%, so a ROIC of less than 10% implies that better returns can be found elsewhere. On the other hand, a ROIC in excess of 25%, is a veritable gold mine for investors.
Growth of £1,000 compounded at different rates:
| Year | 1 | 2 | 3 | 4 | 5 |
| Compounded at 3% p.a. | £1,030.00 | £1,060.90 | £1,092.73 | £1,125.51 | £1,159.27 |
| Compounded at 10% p.a. | £1,100.00 | £1,210.00 | £1,331.00 | £1,464.10 | £1,610.51 |
| Compounded at 15% p.a. | £1,150.00 | £1,322.50 | £1,520.88 | £1,749.01 | £2,011.36 |
| Compounded at 25% p.a. | £1,250.00 | £1,562.50 | £1,953.13 | £2,441.41 | £3,051.76 |
Multiple metrics
Return on Invested Capital can be explained as net income minus dividends divided by total capital. Total capital includes long-term debt, and common and preferred shares and gives a sense of how well a company is using its money to generate returns.
Another metric available through Stockopedia's screening tools is Cash Return On Invested Capital (CROIC or CROCI), which measures how much cash a company generates based on each dollar invested into its operations. It is similar to ROIC but focuses on cash, rather than profits.
ROIC must not be confused with Return on Capital Employed ROCE. ROCE compares earnings with the sum of shareholders' equity and debt liabilities (Total Assets – Current Liabilities). Unlike ROIC, ROCE can be flattered by depreciation, although it is more helpful for measuring efficiency, from a business point of view.
Prime examples
Wells Fargo is a great example of how a high ROIC and compounding can impact long-term returns.Over the past four decades Wells has achieved a mid-teen returns on its equity capital, (15%) compounded book value at 11.1% per annum since 1972, driven stock price growth of 11.4% since 1972. [Here's a great article on Wells' compounding power. It's unsurprising that Wells is one of Buffett's favourite companies]. The same compounding and growth can be seen in the figures of Buffett's most famous investments, Coke.
Coke's return on equity has exceeded 20% for much of the past ten years. Over the same period, book value per share has grown at a CAGR of 11.3% and the company's share price has returned around 11.5% per annum including dividends.
Another Buffett favourite, IBM, has achieve an average ROCI of 25.5% over a rolling ten-year period, driving earnings and book value growth:
Note: as well as book value and EPS growth, IBM's high ROIC has enabled the company to return somewhere in the region of $15bn per annum to shareholders through both dividends and stock buybacks.
Plenty of options
Here in the UK there are plenty of companies that are achieving a high, recurring ROIC, and their returns over the past few decades have been nothing short of impressive.
Next has been one of the London market's most consistent performers over the past decade, thanks to the company's impressive, steady ROIC. This kind of compounding really pays off when it comes to share price growth. Next's share price has risen at 15.3% per annum for the past ten years, excluding dividends, outperforming most indexes.
Johnson Matthey and Unilever are two more 'compounders', which have been able to drive earnings growth by achieving a stable and solid ROIC. Unilever's returns on capital are some of the best on the market, but you have to pay for this kind of quality:
Still, including reinvested dividends Unilever's shares have returned 11.5% per annum over the past decade. Meanwhile, Johnson Matthey's steady ROIC has enabled the company to grow book value at a steady rate, while returning a sizeable amount of cash to investors. Once again, a high ROIC and compounding of book value, along with dividend growth has only had a positive effect on Johnson Matthey's stock price. The company has returned 12.1% per annum for the past ten years - excluding dividends.
Conclusion
ROIC is an extremely important metric and can be a telling indicator of how a company will be able to grow over time. A high ROIC, or ROC usually indicates a wide margin of safety, or competitive advantage, which allows the company in question to generate a higher than average profit margin. These profits can then be reinvested back into the business for book value growth, or distributed to investors. All in all, it really pays to keep an eye on ROIC.
Stockopedia has the ROIC available to be added into all table views and for use in the screener - do take a free trial to get started.
Disclaimer
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21 comments
Paul, I know you like a debate so here goes:
Companies that generate a high ROIC% (and other return numbers) are already doing a lot of things right – Its jam today, not jam tomorrow. It’s also likely that they have a competitive advantage. When high returns are combined with a multi-year track record of increased top line sales and positive momentum, it’s probable that the EPS and share price will rise over the medium term. A good large cap example of this combination is is Next (LON:NXT) whose ROIC is 55% - Look at their 3 or 5Y share price graph
Consistency of high returns and sales growth are important because it shows the ability to keep a step ahead of competitors over an extended period of time.
I am highly sceptical of software such as Vector Vest that claims that, "anyone can make money out of the stock market" - If it is that simple there would be no need to sell it, just put it into play. No spreadsheet is required for the above technique - just Stocko data and research. Ian
I don't think you can predict these things at all.
So the numbers in spreadsheets are total fantasy.
It's good to have estimates in your mind, but anything more than that is just make-believe.
PP.
LH,
All 5 are small cap companies have large spreads which is a big problem if you want to trade them quickly. But their high ROIC's (when combined with other metrics) gives me a degree of confidence that these businesses have what it take to grow and prosper long term. Winners keep on winning - for a while at least! Of these Bioventix (LON:BVXP) and Sprue Aegis (LON:SPRP) are among my "Conviction" shares I expect to hold for several years.
I did look at Bioventix a while ago iwrite7, when Boris was suggesting it as a good growth stock. The main thing that put me off was the huge difference with the bid offer spread. Even now it is 700p bid & 740p offer. That's about 5.7% difference! before you are into profit. A similar high spread is CLIG & I ventured into them a few months ago with the objective of getting the lions share of the dividend of around 7% as well as a bit of profit. It worked but the profit would have been better with a lower bid/offer spread.
ETQ & SPRP are my kind of share although the spreads are still a bit on the high side, the performance makes up for it. Just looking at one of mine SKP @358.8p bid & 364.3p offer which is about 1.53% which is an improvement. I have noticed that when volumes are higher then the bid/offer spread is a lot lower, so timing when you buy comes into the equation.
All of these things makes the difference in the compounding effect of our portfolios.
Just for the record the figures for the other shares are as follows:-
ETQ 8.47%, MAI 2.98% QTX 6.06%, & SPRP 4.6%. That is for today tomorrow is another day. The more transactions, the cheaper is the spread.
Rupert,
Decided I better look a bit more closely at my Portfolio of 19 shares in relation to average ROIC%. I am a mixed criteria investor with a particular eye to quality and my shares are not picked primarily for ROIC. One share (£VLK) is excluded because Stockopedia doesn't calculate an ROIC, but the average ROIC over the other 18 shares is 26.5%, for which I have given myself a pat on the back!
My Top 5 by ROIC% are:
Bioventix (LON:BVXP) 86.9% - Wonderful track record of top line growth and profits
Energy Technique (LON:ETQ) 53.8% - A engineering minnow with F9 score
Maintel Holdings (LON:MAI) 47.9% - Mentioned above
Quartix Holdings (LON:QTX) 39.1% - A new IPO with fantastic 5Y return numbers
Sprue Aegis (LON:SPRP) 34.4% - Biggest holding for growth
Stocko Team It - Would be nice to be able to calculate average Stockopedia portfolio metrics such as ROIC% automatically. As ever DYOR. Ian
Personally I have never done any spread betting with either company. I don't think Gal Harbour, the CEO worries about the rapid growth aspect of the company.
The margins are in fact extremely tight averaging 0.2% between the bid & offer spread which accounts for 70% of revenue. Another 20% of revenue comes from premium products like credit it extends to its customers. The other 10% of revenue comes from customer losses which is PLUS 500d's gain. In addition to that they are encouraging customers to recommend more people to become customers and offering them around $300 reward for doing so. This figure varies according to what country the new customer is from. This is similar to how network marketing principal works and has proven to be extremely successful.
This is why Q3 results stated by Gail Harbour "We have almost trebled our revenues and more than doubled our ARPU (average revenue per user) spend."
The Q4 results are going to be above market expectations, according to Reuters.
Now when you have the business running with just 48 people worldwide, almost fully automatic, the revenue & profit comes from 3 areas.
1. Increasing customer numbers.
2. Increasing customer spend.
3 When 1 & 2 are expanding the revenues go up and thus the margins will increase because those same 48 people will have bigger & bigger average volumes of revenues per person. It used to be averaging about £2M each, The overheads are extremely low & reasonably constant comparing it with IG that has over 1,000 employees.
What that figure per person will be by the end of the year I have no idea, but I am pretty sure it will be an increase
.With this in mind 50% of their profits are paid out to the shareholders & that has already been declared by the CEO to be 8% in the first quarter of 2015, which means that the profits must still be increasing in order to make this payment. Even if the share price is 500p that is 40p per share, should it go to 625p that's 50p per share.
Vector Vest has now valued the company at just over £10.00 per share, so it is still undervalued.
The other thing to bear in mind is they may be looking to be leaving the AIM market to a full listing sooner or later & it will be the first full year of results for them, so I can imagine they want their figures to be good.
I met Plus500 at float. I was pretty impressed. I know a bit about this space, having invested in a similar business before. What put me off when doing some of my own research was just how quickly I could start trading with them. In the new age of the FCA and PRA, I felt that a company that admitted that it did its anti money laundering checks when you tried to withdraw funds rather than at the start when you deposit them could be receiving a visit from said authorities pretty sharpish! Customer sign up have been off the clock and and as yet no visits from the regulator so I have not enjoyed the share price rise. Well done to those that spotted this one.
Surplus cash has to be a good thing for them to advertise their company and get more new customers. That was the whole idea of the IPO in the first place.
I also like to see the operating margins increase consistently each year which has a compounding effect on the profits of the company which effect the dividend pay outs that are being paid at the rate of 50% oft the company's profits. They have already stated the dividend will be 8% for the first quarter of 2015.See Globes English plus500d's latest report.
As you stated at the beginning the average return on stocks has been 7% which makes the 8% first dividend payment extremely attractive. The earnings growth rate forecast from Vector Vest is showing at 43%, so I am expecting the dividends to increase over time.
The whole world economy is gripped in this compound debt interest which must eventually lead to huge problems to be solved.
The one thing that worries me about Plus is the company's rapid growth rate and high margins compared to other companies, market leaders such as IG. Have you ever used their trading platform?
Well we now have two different negative numbers which do not come from the main Stockopedia screen, which I could reasonably expect the figures to be correct. Whilst I agree Rupert that it has a high level of cash, how on earth can you have capital invested as negative, when they don't need to borrow any money! At your calculation = minus 292% & iright7 has a calculation of minus 467%. One of you has to surely to be wrong. Clearly the company is in an increasing profit margin each year.
It qualifies for 4 screens, which are all different of course.
The fact remains they are making a ton of money right now and as you stated it is the best stock in the investment banking sector. So who is right I have no idea?
lightningtiger, like I noted in the comment below, like all metrics ROIC works best when combined with other metrics. For example, even though Plus' ROIC is negative, which is more of a surplus cash issue than anything else, using FCF metrics the company is extremely attractive. However, with so much cash sloshing around Plus could make better use of it's huge cash balance. It's not efficient to be holding so much capital when rates are so low.
Whilst I agree that return on capital is an important investing concept, the reliable measurement of it is fraught with complications which makes its practical application more difficult. In this respect the accounts should only be a starting point, and the subjected to a number of adjustments. Furthermore it should be measured across a number of years.
A point of correction on the calculation though - the article states:
"Return on Invested Capital can be explained as net income minus dividends divided by total capital."
If you are referring to dividends paid, this should definitely not be deducted from net income. Rather, the numerator should be the ungeared earnings of the company i.e. excluding interest less the tax shield thereon; or sometimes referred to as net operating profit after tax.
I also disagree with the statement: "Unlike ROIC, ROCE can be flattered by depreciation".
Regardless of whether the denominator here is based on, for example, fixed assets and working capital, or on equity and debt, depreciation will equally affect both - either by a reduction in fixed assets or a reduction in shareholders' equity. But the more insidious accounting adjustments are the exceptional items such as impairments etc, which is just one of the reasons why the accounts are only a starting point. And that is even before we the impact of goodwill, operating leases etc.
Yes, return on capital is useful, but it needs to be properly measured (or rather estimated) and that usually introduces quite a few complexities which simply won't be captured in the screeners. And that means manually ploughing through years of annual reports, at which point in time many investors will give up....
@miserlyinvestor
I think that there are always downfalls in every valuaion/financial metric, you could pick holes in every single method of valuaion and screener out there. It's all about using a selection of metrics that give the best view.
As you say, ROIC, ROCE and others are all useful, when measure and used properly. Just because many investors will give up trying to arrive at a ROIC figure does not mean that it's a useless number.
Where did you get the figure minus 467% for ROIC from? That is news to me. It is not from Stockopedia. Surely this must be a mistake?
From yesterdays detailed Vector Vest report we have:
Value 992.95p per share therefore it is undervalued compared with it's price of 539p.
Forecast Earnings Growth Rate 43% which V Vest considers Excellent.
P/E 8.96
Earnings yield 11.16%
Sales growth 138%. (This is the compounding effect that is beginning to happen)
This all adds up to great profits for them & it's all mainly automated from just 48 employees.
Hi LT, The -467% ROIC is a Stockopedia calculation. The easiest way to calculate it is the fork an existing screen and add say ROIC >12% into the screening criteria. If your share doesn't appear view the "screen as a checklist" and press the fail tab to see the calculated ROIC% number.
Alternatively add ROIC into one of the screener table result tabs and it should always be calculated. Note some small AIM companies don't compute a ROIC number so you may inadvertently screen out some good un's - not sure why no ROIC appears for these companies (e.g VLK)?
The negative ROIC is quite easy to explain. Due to the high level of cash in the business, capital invested is negative, therefore dividing NPAT of £50.6 by a negative number (-17.3) will give you another negative. I work it out as: ROIC = 50.6/-17.3 = -2.92*100 = -292%
http://www.stockopedia.com/ratios/return-on-invested-capital-824/
Hi Rupert, I have to agree with your compound interest & high ROIC & did a comparison last night through into the morning with IGG & Plus500 which has a massive ROE of 165.8% and the profit margin now standing at 66.4% has been increasing over time too all adding to the compounding factor. The ROC is 132% which I thought were excellent figures. This is mainly brought about because this money making machine is mainly running on automation and only has 48 employees.
Hi lightningtiger, I have no opinion on Plus but looked at the company several times before -- there's no denying the company's growth rate is highly impressive. According to Stockopedia's numbers the company is the best in the Investment Banking & Investment Services Industry for ROE and ROCE, which does concern me, you can have too much of a good thing and in this case the margins are slightly suspect....
I held Plus for a short while then became concerned about the credibility of the numbers. Mr Market must feel the same way or the PE would be higher. Another oddity is the Plus ROIC number which is -467% (minus).
Rupert,
I agree that ROIC is a great metric to screen for quality companies. Excellent and informative article.
One under the radar AIM company I have recently taken a position in is Maintel Holdings (LON:MAI) which is a £69M Telecoms minnow. A recent acquisition has re-rated the share and the current ROIC is 64%. Whilst this might seem ridiculously high, ROCE as been over 40% for the last 5 years, so it has form. At a Stockopedia PER of just 11.6 with good RS its a ROIC bargain I think? As ever DYOR.
Stockopedia team - Unless I Have missed it, it would be nice to screen for 5Y ROIC as well as 5Y ROCE.
Ian
Ian,
Thanks for bringing Maintel Holdings (LON:MAI) to my attention, it looks like an interesting play, that high ROIC is really compounding book rapidly. I'd want to understand why the return on capital is so high though...it's one of the best around according to stockopedia's figures. Definitely one for further research over the weekend!
Rupert