Barbara Tuchman wrote in the The March of Folly, “Wisdom, which may be defined as the exercise of judgment acting on experience, common sense and available information, is less operative and more frustrated than it should be.” In her seminal work, she provided a plenitude of examples to prove her point: from the story of the Trojans and the wooden horse to a detailed description of how Renaissance Popes provoked the Protestants. She showed how government clearly acted against its self-interests when there were other options to choose from. And that it was a collective of individuals who took the wrong path and just one despot. Alas, she coined the situation: a folly.
A folly can be seen in the world of stock investing too. For example, a simple but useful profitability ratio, called return on invested capital (ROIC) ratio has been used for decades by gurus investors such as Bruce Berkowitz and Joel Greenbaltt. Yet not only is the ratio rarely discussed today, there is even confusion on how to properly calculate it.
Some use net operating profit after taxes (NOPAT) in the numerator while others use earning before interest (EBIT). In the denominator, some investors use tangible equity (effectively removing the other comprehensive income (OCI) component and other intangible items, such as goodwill. And others use year-end figures, or they average the begin- and year-end book value.
Similar to most of our terminology in the stock investing world, there are no clear definitions and each approach has its advantages. Two important things are consistentcy and logic: choose in the numerator a cash flow measure and in the denominator a number that best describes how much capital was invested in the business.
To find the ROIC, I take the free cash flow and divide it by the average stockholder equity balance. For simplicity’s sake, free cash flow is the cash flow from operations less capital expenditures, and the average stockholder equity is the sum of the beginning and year-end balances divided by two.
We can use the operating financials of Caesarstone Ltd., (CSTE), a quartz surfaces manufacturer, to illustrate the math. In 2017, CSTE cash flow from operation was $61 million and its capital expenditures were $23 million which gets us to $38 million in free cash flow. The company had 34 million dilutive common shares, or $1.11 free cash flow per share. Now take a look at its balance sheet, and you will see that the book value per share was $13.66 at the beginning of 2017 and $12.59 at its year-end. So, the average book value per share was $13.13 and the 2017 ROIC was 8.45%.
ROIC provides an estimate of how successful the managers of the company are in deploying capital. Or simply: how profitable the business is. It also gives a rough estimate of how profitable the industry is as a whole. Let's compare the ROIC of the highly admired Apple Inc., (AAPLE) compared to GE Electric (GE). In 2017, using the definition above, Apple's ROIC was 40% and its five-year average ROIC was 45%. Compare that to GE's ROIC of 4% and its five-year average ROIC of 6%. Unsurprisingly, perhaps, Apple's stock trades today at $187 compared to about $70 five years ago, while GE's stock trades today at $15 compared to about $24 in 2013.
In short, capital markets favor companies and industries that demonstrate high, double-digit ROIC. And calculating the ROIC also allows you to compare among companies operating in the same industries.
Let us return to Caesarstone and compare its ROIC to other companies that operate in the building material industry. Headquartered in North Carolina, United States, Martin Marietta Materials (MLM) ROIC was 5% in 2017 and its five-year ROIC was 11%. Another company is Vulcan Material Company (VMC), an American company based in Birmingham, Alabama, that engages in the production, distribution and sale of construction materials. VMC’s ROIC was 4% in 2017 and its five-year ROIC average was 4%.
From that we can deduce that CSTR’s profitability lies roughly between the two firms.
Now that you know what ROIC is and what it represents, I invite you to further explore the ratio and its implication. Visit Magic Formula, a website that ranks companies based on their return on invested capital. And if you download the publicly available financials of the companies listed, you can examine why the website ranked the companies as it did.
Another free stock screener can be found at https://fintel.io/screen/roic-return-on-invested-capital-screen. Similar to Magic Formula, the exercise here would be to determine whether you agree or disagree with the stock screener. Write to me if you would like to see some examples of my work.
From there, you can visit Gurufocus. In the article Return on Invested Capital in 2 Easy Steps, Dave Ahern mentions a different methodology to calculate ROIC. His article is well detailed with excellent examples.
Finally, over the next few months, I will meditate on other investing concepts that are hidden from the investing jargon but can bring a lot of value. If you would like to be notified when I post these meditations, please click the button at the top of this page.