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HEROES

AT&T <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: T)") else Response.Write("(NYSE: T)") end if %> rang up $15/16 to $58 5/8 after reporting second quarter earnings of $0.91 per share (before unusual items), up from $0.57 in the year-earlier period and a penny ahead of estimates, as aggressive cost cutting offset poor revenue growth. AT&T's revenues only gained a slight 1% to $12.858 billion. The nation's largest long-distance company had after-tax charges of $1.04 a share related to its voluntary retirement incentive program, which has been accepted by about 13,500 managers, but the company expects gains of some $700 million in the second half of the year as pension benefits obligations are settled. AT&T expects 1998 operating EPS of $3.35 to $3.45 on revenue growth of 2% to 4%, including the results of local phone company Teleport Communications Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: TCGI)") else Response.Write("(Nasdaq: TCGI)") end if %>, which today rose $1 to $55 1/8. The $13 billion acquisition of Teleport was approved today by the FCC. AT&T also announced plans to buy back $3 billion in shares. Cable company Tele-Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: TCOMA)") else Response.Write("(Nasdaq: TCOMA)") end if %>, which has agreed to be acquired by AT&T, rose $5/8 to $40. To listen to the conference call replay, dial (800) 475-6701 and enter access code 398198, or for the online rebroadcast go to http://www.att.com/ir/.

Beer brewer, theme park operator, and aluminum can maker and recycler Anheuser-Busch <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BUD)") else Response.Write("(NYSE: BUD)") end if %> gained $1 5/8 to $52 3/8 after yesterday reporting Q2 EPS of $0.80 compared with $0.76 last year. Analysts had expected EPS of $0.77. Worldwide sales of its own beer brands rose 2.2% to 26.1 million barrels during the quarter. Total beer sales, which include the company's stake in foreign beer companies, gained 7.5% to 28.8 million barrels. The company said there has been less discounting in beer prices since the end of last year, but domestic revenue per barrel still fell 1.4%. As previously announced, the company expects full-year EPS growth in the mid-single digits. The world's largest brewer also announced an increase in its quarterly dividend to $0.28 from $0.26 a share. The company's better-than-expected results prompted several earnings upgrades: Goldman Sachs placed it on its "recommend list," Morgan Stanley Dean Witter raised it to "outperform" from "neutral," and DLJ upped it to "market perform" from "underperform."

QUICK TAKES: WorldCom <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: WCOM)") else Response.Write("(Nasdaq: WCOM)") end if %> picked up $1 1/16 to $55 3/8 after reporting Q2 EPS of $0.21 compared with $0.04 (before special items) in Q2 1997. Operating income increased 127% to $494.8 million. MCI Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MCIC)") else Response.Write("(Nasdaq: MCIC)") end if %>, which has agreed to be acquired by WorldCom, moved up $15/16 to $66 3/4... No. 3 U.S. automaker Chrysler <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: C)") else Response.Write("(NYSE: C)") end if %> rose $9/16 to $58 3/4 on news that the European Commission has granted unconditional clearance to the proposed merger between Chrysler and Daimler-Benz <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DAI)") else Response.Write("(NYSE: DAI)") end if %>. The Mercedes maker cruised up $1 9/16 to $101 1/8... Food and beverage company Quaker Oats <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: OAT)") else Response.Write("(NYSE: OAT)") end if %> added $2 1/8 to $53 7/8 after reporting Q2 EPS of $0.76 (before unusual items), up from $0.65 a year ago and topping analysts' expectations of $0.71. The company said strong sales of Gatorade led the advance in earnings.

Some companies that took a beating yesterday recovered some today. Software company Computer Associates <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CA)") else Response.Write("(NYSE: CA)") end if %>, which was hammered yesterday after warning about future earnings growth, regained $1 1/8 to $40 5/8. Computer, printer, and measurement devices maker Hewlett-Packard (NYS: HWP), which issued a Q3 earnings warning, picked up $2 1/16 to $57 7/16... Biotechnology company Amgen <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AMGN)") else Response.Write("(Nasdaq: AMGN)") end if %> jumped $4 3/4 to $76 5/16 after announcing Q2 EPS of $0.82 compared with $0.72 a year ago and analysts' mean estimate of $0.74... Pharmaceutical company Baxter International <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BAX)") else Response.Write("(NYSE: BAX)") end if %> gained $1 1/16 to $56 11/16 after reporting Q2 EPS of $0.62 (before charges), up from $0.57 in the prior-year period and in line with estimates. Revenues grew 5% to $1.65 billion.

Internet service provider PSINet <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: PSIX)") else Response.Write("(Nasdaq: PSIX)") end if %> shot up $3 5/16 to $19 1/4 on speculation that it may be acquired by AT&T or some other company... Internet network and TV programming company CNET Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CNWK)") else Response.Write("(Nasdaq: CNWK)") end if %> surged $6 1/4 to $70 3/4 after reporting its first profitable quarter in terms of operating income. The company had Q2 EPS of $0.02, compared with a loss of $0.37 in the year-ago period... Internet service provider MindSpring Enterprises <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSPG)") else Response.Write("(Nasdaq: MSPG)") end if %> powered up $8 11/16 to $149 after reporting late yesterday Q2 EPS of $0.24, up from a loss of $0.19 in the year-earlier period. Analysts had predicted EPS of $0.18. Revenues more than doubled to $25 million from $11.6 million a year ago... Internet, online, and CD-ROM games developer Interactive Magic <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: IMGK)") else Response.Write("(Nasdaq: IMGK)") end if %> shot up $4 15/16 to $14 from an initial offering price of $8 a share.

Beer brewer Adolph Coors Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ACCOB)") else Response.Write("(Nasdaq: ACCOB)") end if %> added $2 9/16 to $39 1/2 after reporting Q2 EPS of $1.06, up from $0.96 (before unusual items) a year ago. Analysts had expected EPS of $1.01... Drug developer Isis Pharmaceuticals <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ISIP)") else Response.Write("(Nasdaq: ISIP)") end if %> was up $3/4 to $14 3/16 after announcing with CIBA Vision Corp., the eye care unit of Novartis AG, that an FDA panel has voted to recommend approval of Vitravene for the treatment of cytomegalovirus retinitis in AIDS patients... MetroNet Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: METNF)") else Response.Write("(Nasdaq: METNF)") end if %> tacked on $1 1/16 to $29 11/16 after pricing its previously announced offering of 8.125 million Class B non-voting shares at $28 5/8, yesterday's closing price... Metal-based specialty chemicals and powders manufacturer OM Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: OMP)") else Response.Write("(NYSE: OMP)") end if %> jumped $1 11/16 to $35 5/16 after Morgan Stanley Dean Witter raised its rating on the company to "strong buy" from "outperform."

Earnings Movers

Atlantic Data Services <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ADSC)") else Response.Write("(Nasdaq: ADSC)") end if %> up $1 to $16 1/8; Q1 EPS: $0.18 vs. $0.10 last year; Estimate: $0.13

Autoliv Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ALV)") else Response.Write("(NYSE: ALV)") end if %> up $1 1/4 to $30 5/16; Q2 EPS: $0.50 vs. $0.47 last year; Estimate: $0.44

Bell & Howell Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BHW)") else Response.Write("(NYSE: BHW)") end if %> up $2 3/16 to $29 1/2; Q2 EPS: $0.38 vs. $0.23 last year; Estimate: $0.30

Cadence Design Systems <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CDN)") else Response.Write("(NYSE: CDN)") end if %> up $1 5/8 to $30 1/8; Q2 EPS: $0.28 vs. $0.21 (before charges) last year; Estimate: $0.27

Concord Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CCRD)") else Response.Write("(Nasdaq: CCRD)") end if %> up $5 1/8 to $33 3/4; Q2 EPS: $0.08 vs. loss of $.04 last year; Estimate: $0.06

Dal-Tile International <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DTL)") else Response.Write("(NYSE: DTL)") end if %> up $1 1/8 to $10 7/8; Q2 EPS: $0.10 vs. loss of $0.26 last year; Estimate: $0.06

Excel Switching Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: XLSW)") else Response.Write("(Nasdaq: XLSW)") end if %> up $2 3/8 to $26 5/8; Q2 EPS: $0.17 vs. $0.12 last year; Estimate: $0.15

Intelligroup Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ITIG)") else Response.Write("(Nasdaq: ITIG)") end if %> up $2 1/4 to $20 1/8; Q2 EPS: $0.19 (before charges) vs. $0.11 last year; Estimate: $0.15

Knoll Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KNL)") else Response.Write("(NYSE: KNL)") end if %> up $1 5/16 to $35 1/4; Q2 EPS: $0.57 vs. $0.41 (pro forma) last year; Estimate: $0.49

K2 Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KTO)") else Response.Write("(NYSE: KTO)") end if %> up $3 1/4 to $18 9/16; Q2 EPS: $0.49 vs. $0.52 last year; Estimate: $0.48

Ontrack Data International <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ONDI)") else Response.Write("(Nasdaq: ONDI)") end if %> up $1 1/8 to $11 7/8; Q2 EPS: $0.15 vs. $0.12 last year; Estimate: $0.15

Providian Financial <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PVN)") else Response.Write("(NYSE: PVN)") end if %> up $1 11/16 to $81 15/16; Q2 EPS: $0.65 vs. $0.48 last year; Estimate: $0.62

Rio Hotel & Casino <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: RHC)") else Response.Write("(NYSE: RHC)") end if %> up $1 to $17 15/16; Q2 EPS: $0.18 vs. $0.31 last year; Estimate: $0.12

GOATS

Commercial and military aircraft maker Boeing Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BA)") else Response.Write("(NYSE: BA)") end if %> dropped $6 1/4 to $41 1/2 after reporting fiscal Q2 EPS of $0.26 compared to $0.48 last year, missing the First Call mean estimate of $0.33. The results include $78 million in charges to end production of the MD-11 jetliner and account for late delivery costs for its updated 737. The Next Generation 737s have caused headaches all year, as the project has been beset with parts shortages and other dilemmas since March. However, the jets serve the important short- to medium-range routes the firm needs to dominate in order to fend off further market share advances by rival Airbus. To get the company back to its traditional place as a world-class manufacturer, Boeing's management is dedicating itself to raising annual net return on sales to 7% from the current level of less than 2% and bumping up its annual number of inventory turns to four from two.

Physician practice management firm PhyCor <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: PHYC)") else Response.Write("(Nasdaq: PHYC)") end if %> fell $5 9/32 to $8 25/32 after reporting fiscal Q2 EPS of $0.22 versus $0.20 a year ago, which was in line with the Street's estimate. The company said it will take a $65 million charge in Q3 to realign its "group formation" physician operations. The company also said "confusion" brought about in the industry by recent blow-ups at other physician practice managers is impacting PhyCor's near-term growth. Consequently, fiscal 1998 earnings will be about 10% below previous targets. MedPartners <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MDM)") else Response.Write("(Nasdaq: MDM)") end if %>, which is being blamed by PhyCor in spirit if not in name for part of the confusion, fell $1 1/16 to $5 1/4. PhyCor is also probably sticking pins in a voodoo doll representing FPA Medical Management <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: FPAM)") else Response.Write("(Nasdaq: FPAM)") end if %>, which recently filed for Chapter 11 bankruptcy and now resides in Penny Stock-land.

QUICK CUTS: Troubled consumer products giant Cendant Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CD)") else Response.Write("(NYSE: CD)") end if %> fell $3/4 to $16 1/16 as 44 senior executives at the firm called for the removal of Chairman Walter Forbes following alleged accounting fraud at the CUC business he led... Retailing heavyweight Sears, Roebuck & Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: S)") else Response.Write("(NYSE: S)") end if %> sank $5 3/8 to $51 5/16 despite reporting fiscal Q2 EPS of $0.85, beating the First Call mean estimate by a penny... Property/casualty insurer and former Sears unit Allstate Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ALL)") else Response.Write("(NYSE: ALL)") end if %> lost $2 5/8 to $45 7/8 on a Lehman Brothers downgrade to "outperform" from "buy"... Online bookseller Amazon.com <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AMZN)") else Response.Write("(Nasdaq: AMZN)") end if %> slid $6 3/8 to $127 5/8 after reporting a fiscal Q2 loss of $0.44 per share including charges. Excluding charges, the company lost $0.33 per share. The consensus analyst estimate was for a loss of $0.44 per share.

Golf club maker Callaway Golf Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ELY)") else Response.Write("(NYSE: ELY)") end if %> was sliced $6 1/4 to $12 3/4 after reporting fiscal Q2 EPS of $0.30, missing the Street estimate by $0.02. The Asian financial crisis is expected to cut into results during the rest of the fiscal year, leading to a second half loss of as much as $0.20 per share... Teenage casual clothes retailer Gadzooks <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: GADZ)") else Response.Write("(Nasdaq: GADZ)") end if %> was trounced for $7 1/2 to $11 1/4 after saying it will report fiscal Q2 EPS between $0.07 and $0.10 due to slow sales in July. The First Call mean estimate called for EPS of $0.22... Wireless communications products maker Qualcomm <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: QCOM)") else Response.Write("(Nasdaq: QCOM)") end if %> gave back $3 7/8 to $63 1/4 after rising 17% yesterday on reporting fiscal Q3 EPS of $0.33 (excluding charges), well ahead of the $0.26 expected by the Street.

Auto loan securitization and servicing firm Arcadia Financial <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AAC)") else Response.Write("(NYSE: AAC)") end if %> stalled $1 3/16 to $6 1/16 after reporting a fiscal Q2 loss of $2.41 per share compared to earnings of $0.15 per share last year. The results included a $115 million charge to adjust accounting estimates to reflect lower default recovery rates and slower prepayment rates... Long-term healthcare facilities operator Beverly Enterprises <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BEV)") else Response.Write("(NYSE: BEV)") end if %> was knocked down $5 3/16 to $9 7/16 after saying that federal authorities are investigating how its skilled nursing centers allocated labor costs to Medicare during 1990 to 1997... Long-term disability insurance provider UNUM Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: UNM)") else Response.Write("(NYSE: UNM)") end if %> slipped $3 5/16 to $52 1/2 after reporting fiscal Q2 EPS of $0.70, beating the Street's estimate by a penny. However, Merrill Lynch lowered its near-term rating to "accumulate" from "buy."

Oilfield services company Halliburton <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HAL)") else Response.Write("(NYSE: HAL)") end if %> lost $3 to $37 7/8 after reporting fiscal Q2 EPS of $0.51 versus $0.40 a year ago. The company's president told Reuters that the second half of the year will be "tough" and possibly less profitable than forecasted six months ago... Satellite-based telecommunications network operator Iridium World Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: IRIDF)") else Response.Write("(Nasdaq: IRIDF)") end if %> slipped $7 7/16 to $46 3/4 after Merrill Lynch lowered its near-term rating to "neutral" from "accumulate"... Managed care provider Oxford Health Plans <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: OXHP)") else Response.Write("(Nasdaq: OXHP)") end if %> slid $1 15/16 to $10 9/16 on reports that the company has told doctors it needs to hike premiums and cut physicians' payments in order to be profitable.

Healthcare management software firm HBO & Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: HBOC)") else Response.Write("(Nasdaq: HBOC)") end if %> fell $5 5/8 to $27 1/4 after agreeing to buy electronic healthcare information systems developer IMNET Systems <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: IMNT)") else Response.Write("(Nasdaq: IMNT)") end if %> for about $270 million in stock. IMNET jumped $5 3/16 to $21 7/16... Wireless network synchronizing products maker Datum Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DATM)") else Response.Write("(Nasdaq: DATM)") end if %> slid $4 11/16 to $11 15/16 after reporting fiscal Q2 EPS of $0.01, missing the Street's estimate by a penny. Margins are expected to decline in the second half, which may result in "moderate" operating losses... Casual clothing retailer Nautica Enterprises <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NAUT)") else Response.Write("(Nasdaq: NAUT)") end if %> lost $3 1/4 to $24 3/4 after NationsBanc Montgomery Securities downgraded the company to "hold" from "buy" along with rivals Tommy Hilfiger Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TOM)") else Response.Write("(NYSE: TOM)") end if %> and Polo Ralph Lauren <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: RL)") else Response.Write("(NYSE: RL)") end if %>. Hilfiger fell $6 5/8 to $51 3/8 and Polo dropped $1 1/4 to $27.

Discount broker Charles Schwab <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SCH)") else Response.Write("(NYSE: SCH)") end if %> slid $3 5/8 to $39 1/4 after denying market rumors that it is for sale... Air carrier Trans World Airlines <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: TWA)") else Response.Write("(AMEX: TWA)") end if %> slipped $9/16 to $9 after PaineWebber cut its rating to "neutral" from "attractive"... Long-distance phone service provider Tel-Save Holdings <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: TALK)") else Response.Write("(Nasdaq: TALK)") end if %> slumped $1 1/8 to $15 15/16 as the company said it has been a approached by an unspecified but "Internet-related" suitor about a possible merger... Cardiac medical device maker St. Jude Medical <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: STJ)") else Response.Write("(NYSE: STJ)") end if %> lost $3 1/2 to $26 1/2 after receiving downgrades from John G. Kinnard and Donaldson, Lufkin & Jenrette.

Earnings Movers

Adaptec Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ADPT)") else Response.Write("(Nasdaq: ADPT)") end if %> down $11/16 to $12 1/16; Q1 EPS: $0.10 (before charges) vs. $0.51 last year; Estimate: $0.15

ChemFirst Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CEM)") else Response.Write("(NYSE: CEM)") end if %> down $1 15/16 to $20 13/16; Q2 EPS: $0.20 vs. $0.38 last year; Estimate: $0.22

Fairfield Communities <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FFD)") else Response.Write("(NYSE: FFD)") end if %> down $4 7/8 to $10 3/16; Q2 EPS: $0.28 vs. $0.23 last year; Estimate: $0.28

Imperial Chemical Industries <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ICI)") else Response.Write("(NYSE: ICI)") end if %> down $10 to $49 7/8; Q2 EPS: $0.46 (before goodwill and charges) vs. $0.69 last year; Estimate: $0.75

N2K Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NTKI)") else Response.Write("(Nasdaq: NTKI)") end if %> down $1 15/16 to $18; Q2 EPS: $1.18 loss vs. $1.90 loss last year; Estimate: $1.09 loss

FOOL ON THE HILL
An Investment Opinion
by Dale Wettlaufer

Return on Invested Capital (Part 5)

In Part 4 of our series on return on invested capital (ROIC), we looked at an example of a company that earned a steadily declining return on the capital invested in its business. At the end of year 7, the company had after-tax operating earnings of $298.60 and was barely beating its cost of capital. By this time, the company had $1,791.6 in equity capital and $2,090.2 in debt (together, they equal invested capital at year-end).

If investors only considered the cost of debt, then it would look like the company was adding value to the capital at its disposal because earnings before interest and taxes in year 7 would be $459.38, much higher than the cost of debt with average debt of $1,791.61 (at 10%) in use in year 7. With that debt load, the company's interest expense would be $179.16 in year 7, giving the company interest coverage of 2.56 times, well within the comfort zone. After tax savings of $62.71 (35% of interest expense, which is to say, the company's tax rate times its interest expense) that the company receives from using debt rather than equity, the cost of debt capital is $116.45.

However, even though the cost of equity does not show up on a company's income statement, it is not free. Investors expect a rate of return on equity that is in line with the S&P 500 and that also takes into account the specific risks of the company in question. In this case, we have a company that has an average debt-to-equity ratio of 109% in the year 7 and may also be operating in a slower-growth industry with poor economics to begin with. In that case, we would demand a rate of return on equity of about 1.2 times the S&P 500's historical return to compensate for the extra risk. That means that the equity being used by this business will cost it 13.2%. A lower return on equity will hurt the valuation of the company's equity and ultimately the multiple the market will pay for all the capital invested in the business as well as its earnings and cash flow.

Over the course of the year, the example company has $1,642.3 of equity in use. At 13.2% (the company gets no tax savings on this, since earnings attributable to equity are taxable), the cost of equity in use over the course of the year is $216.78. Combined with the after-tax cost of debt, the company's total cost of capital is $333.23, far less than the company's return on invested capital. The proof of this is found in calculating the company's weighted average cost of capital on a percentage basis. Average capital in use over the course of the year equals $3,433.9. Average equity amounts to 47.826% of average invested capital and average debt amounts to 52.17% of average capital. Therefore, the 47.826% of the capital costs 13.2% and the other 52.17% of the capital costs 6.5%, both after tax. To work out the weighted average cost of capital (WACC), multiply 0.47826 by 0.132 and add that to the product of [0.5217 times 0.065]. That equals 0.097041, or 9.7041%. Multiplying WACC by average total capital in use throughout the year, the cost of capital for the company was $333.23.

In this case the company should trade below the value of its capital because it will continue to destroy value. If the enterprise were priced at one times invested capital, the equity value of the company would be equal to invested capital minus net debt, which puts equity value at $1,791.59. Over the course of six years, the stock of the company has appreciated by 79.2%, or 10.2% annually. At the end of the the period, the company's price/earnings ratio has shot up to 21.3, which doesn't seem intuitive with net income being so heavily weighed down by net interest expense. However, at this point, investors are paying for a pile of capital and potential earnings and not so much the current earnings. As the company stands at the moment, it will sap away all shareholders' equity and its creditors will take control eventually.

Rather than acting as a stand-alone conception of how well a company is operating, ROIC should be looked at in relation to the company's cost of capital. Companies such as Coca-Cola <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KO)") else Response.Write("(NYSE: KO)") end if %> have operated on this system, called Economic Value Added, or EVA, for a number of years (as have leveraged buyout financiers). The philosophy doesn't make these companies successful -- it's the implementation of it that makes a difference. Not all successful companies operate based on EVA, either. Some managements think in this way to begin with. However, the readers should know that some of the biggest generators of shareholder value over the last two decades have embraced this philosophy. The company in our example would have stopped growing at a certain point to preserve shareholder value, forgoing growth for growth's sake.

At a certain point, as we see in our example, more of the value of the enterprise goes to its creditors than to its shareholders. When ROIC starts to drop (return on marginal invested capital is a good early warning sign of this), investors should pay attention. It can signal anything from a momentary blip in the company's progress to a decay in industry or company fundamentals. Successful companies in more mature industries (the characteristics defining success for companies in hypergrowth industries are much different) generate ROIC above and beyond their cost of capital -- in fact, this is one reason why the S&P 500 is priced the way it is and why it has outperformed the small and mid-cap universes.

Companies in the S&P 500 are simply the creme de la creme of American business and show a better spread between their return on invested capital and the cost of capital they use. In addition, the very good S&P 500 companies are able maintain excellent returns on invested capital even as they increase invested capital year after year, while others rationalize their operations and sell off those units that can't generate the ROIC that they see elsewhere in their company. By dumping such operations, a company's earnings can shrink, but the valuation on the remaining earnings and capital invested in the business can increase so that the company is now worth more.

By looking at a company's financials from the standpoint of ROIC, an investor considers what's going on with both the income statement and the balance sheet. The various ratios that an investor considers (leverage, cash conversion cycle elements, margins, asset turnover) are brought together under the unified ROIC model. ROIC also allows an investor to look through the various accounting choices that a company can make to portray earnings. As most accounting regimes are rich in balance sheet accruals, ROIC is able to identify the real economic return a company generates. Those expenses that don't go into net income stay home on the balance sheet as part of the company's invested capital. So, what doesn't get considered in the numerator in ROIC has to be considered in the denominator.

Return on invested capital is a highly flexible tool with which all investors should seek to familiarize themselves. It is as basic as being able to calculate earnings per share or the current ratio. Advanced investors seeking to increase their knowledge of these concepts should consider purchasing Bennett Stewart III's The Quest for Value: The EVA Management Guide.

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