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April 20, 1999

Declining ROIC

By Dale Wettlaufer (TMF Ralegh)

In part 3 of this series on ROIC, we discussed how investors can look through reported earnings performance to get at true economic performance. Let's recap this discussion again before we move on, just to make sure everyone is on board the ol' Return on Invested Capital Bus. Bennett Stewart's basic thesis in The Quest for Value: The EVA Management Guide is that return on invested capital allows an investor to see the cash-on-cash return of a business. The cash-on-cash return is literally the amount of cash you get back compared with the amount of cash you had to invest in the business -- thus, the phrase "return on invested capital," or ROIC for short.

After removing all of the distortions created by GAAP accounting, looking at return on invested capital allows you to accurately measure how much cash you get out of a business for every dollar you put into it. The general rule is that the more cash you can get per dollar of investment, the better the business is. Now, whether the cash you are investing into the business is called an "expense" and simply deducted from revenues (like Cost of Goods Sold or Sales, General & Administrative expenses on the Statement of Income) or whether those expenses are "capitalized" and turned into an asset that is placed on the Consolidated Balance Sheet, ROIC can let you see how well the company is actually doing, independent of the accounting method chosen by a company's management.

Looking at ROIC tells an investor how efficiently the company is being run and how much cash is being generated per dollar of investment, independent of how management chooses to finance the company. Whether the company is financed with equity (by selling stock) or debt (by drawing on a bank line of credit or selling debt directly to interested investors), ROIC doesn't care. The idea is to have some sense of what the company's operating performance is regardless of the particular way that the company has financed its invested capital. This allows you as a potential shareholder (and business owner) to discern between the actual operating performance of the business and the side effects of how that business was financed.

You want to look at operating performance independent of financing because conventional accounting does not treat all financing costs equally. While interest, the cost of debt, is reflected on the income statement, the more intangible (but no less real) cost of the equity capital is not reflected at all. What? You mean equity costs money? You bet your sweet belled cap it does! When a shareholder like yourself gets equity (or stock, for those inclined toward the less pretentious version), do you expect that the stock will increase in value? How much do you expect it to increase in value? That percentage increase is the cost of equity capital -- if investors do not get the return they expect, they will sell the stock to a new investor, who comes in expecting to earn his target return on the lower share price. The consensus expectation of all investors who own the stock is the cost of equity capital. Just because it is not deducted out of earnings like debt doesn't make it any less real.

This is why ROIC is so powerful. ROIC looks at earnings power in the context of how much capital is tied up in a business and what sort of return that capital is generating. The whole idea of "earnings growing by such-and-such" takes on less importance as a stand-alone concept when you're looking at how much capital is being poured into a business. It is real easy to grow your earnings by investing more money into the business. However, it is not quite as easy to grow earnings by investing capital if you intend to maintain your current level of return on invested capital. A basic illustration is in order.

Say there's a company that is able to grow operating earnings by 20% per year for six years, and you purchase it a P/E of 10. "Such a deal," you might think. The conventional wisdom of investing teaches that P/E is a determinant of value and that a company growing at 20% per year should be worth far more than 10 times trailing earnings. However, while you're focusing on all that earnings growth, you might miss a deteriorating underlying trend of declining economic performance -- or in English, you may not notice that return on invested capital is dropping like a stone as the company invests in projects that earn smaller and smaller returns. (AOL users please expand window to view table.)

After-tax operating Invested     ROIC   Operating Earnings
  earnings          Capital                  Growth
Year                 $500         

1     $100           $600         18.2%         20%

2     $120           $740         17.9%         20%

3     $144           $999         16.6%         20%

4     $172.8         $1,398.6     14.4%         20%

5     $207.36        $2,097.9     11.9%         20%

6     $248.83        $2,986        9.8%         20%

7     $298.60        $3,881.8      8.7%         20%