A Good Metric is Hard to Find - Return on Capital

by Scuttlebutt Investor


“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” 

– Warren Buffett, 1992 Berkshire Hathaway Shareholder Letter

 

Return on Capital or Return on Invested Capital (ROIC) is something I think about a lot. The list of metrics I look at when I analyze businesses is long: revenue growth, operating margins, free cash flow, payout ratios, etc. But if I could look at only one metric about a business to judge the quality of that business- ROIC would be the metric. Good businesses generate high returns on capital and they do so with consistency. Return on capital is important because it is a fundamental driver of valuation. Businesses that can generate higher returns on capital can invest less in capital expenditures and thus generate more free cash flow to distribute to shareholders. Since value is the present value of future cash flows, this makes these businesses more valuable all else being equal.    

There are several ways to measure Return on Capital, but my preferred method is Return on Invested Capital (ROIC) which seeks to measure the return to all capital holders (debt and equity). ROIC basically computes the underlying return that a business earns on its cumulative investments in the business, no matter how those investments are financed. ROIC is a ratio of a company's After-tax Operating Income to the Capital Invested in the company. The nuances of calculating ROIC can be hotly debated by finance nerds like myself but my preferred approach is what is often referred to as the Asset Approach. I prefer the asset approach because the denominator consists of the assets that a business has invested in so it is a bit more telegraphic of the core drivers. The formula is:

 

ROIC = NOPAT / Invested Capital

 

Let's unpack that a little more though:

Numerator
Net Operating Profit After Tax (NOPAT) = Operating Income x (1 - normalized tax rate) 

Note: Operating income should be adjusted for special or non-recurring charges as appropriate

 

Denominator
Invested Capital = Net Working Capital + Net PP&E + Other Operating Assets - Excess Cash
Net Working Capital = Current Assets - Non-debt Current Liabilities
Excess Cash = Cash on Balance Sheet - Required Cash

Note that the traditional definition of Net Working Capital usually excludes cash from the Current Assets but I include it in this case because we then subtract out the excess cash

 

Putting It in Practice

I recently calculated ROIC for two very different companies with two very different business models and I thought that the output was worth sharing. Putting both calculations side by side helps exemplify the definition and various drivers a little better. Costco (COST) - a traditional brick and mortar retailer and the Company formerly known as Google -Alphabet (GOOG) - a web search company (among many other things) are two very different companies with very different business models and their respective ROICs drive this home.

ROIC graphic.png

I've made some assumptions here and I can't say with certainty that all of them are perfectly correct. Some of the items lumped in with "Other Operating Assets" may not be pure operating assets. And I've made a high level guesstimate of required cash based on what I know about the businesses. Also, I have not made adjustments to capitalize leases here, which should normally be done for lease heavy business models.  Luckily, Costco owns much of its property so it's not as big an issue here. Nonetheless, these assumptions don't impact the key insights of the comparison very much so I thought it ok for this example.

My observations and insights:

Alphabet and Costco are massive businesses with immense scale. They both generate an incredible amount of revenue - $75bn and $118bn respectively, but their operating margins are vastly different. Costco, as a retailer, operates on razor thin ~3% operating margins while Alphabet, as a software/web services company, churns out robust ~26% operating margins. This results in massive differences in their operating income - Alphabet - the company with much lower revenue ($43bn lower in fact), actually generates vastly more operating income - $13.5bn more.

The higher operating margin alone doesn't make Alphabet a better business than Costco.  After all, it's important how much money is spent to generate this operating income. This is the where the all important denominator comes in - Invested Capital.

I was surprised by Alphabet's total invested capital of ~$52bn, which is much higher than Costco's at ~$15bn. I would have expected the brick and mortar business of Costco with its ~700 gargantuan warehouses to surely be larger than what I thought was Alphabet's asset light business model. I underestimated Alphabet's offices all over the world and their massive investment in data centers (referred to as information technology assets on their BS).  

Despite a significantly larger capital investment, Alphabet still comes out on top when it comes to ROIC - with more than double the ROIC at ~34% versus ~15% for Costco. While the large capital invested denominator for Alphabet is a drag on ROIC, the larger numerator (NOPAT) more than makes up the difference. Costco's ROIC is still respectable on its own and definitely for the retail industry (which has historically averaged ~10% ROIC as an industry), but its low margins are no match for Alphabet.   

Does this mean that everyone should go out and buy Alphabet stock?  Not quite.  A few things I would say here:

  • Sustainability: We would want to analyze the ROIC for both companies over multiple years to understand how sustainable it is and how susceptible it is to a cyclical downturn
  • Drivers: Need to understand the core drivers of the calculation. What is driving the higher or lower ROIC and are the right inputs being used?
  • Context: We can't look at ROIC in isolation. We need to look at other metrics and also understand the core business and business model.
  • Valuation is the other side of the coin. Alphabet a wonderful business but only if we're able to pay a fair price. A Ferrari is a hell of a car but it's not a great buy if you pay a billion dollars for it. It's also worth mentioning the inherent risk of the business models - one could argue that Costco is less risky than Google because it operates in a more traditional industry where product life cycles aren't changing by the minute. This latter point is debatable (have you heard of Amazon?). But let's pause a moment and talk more about the interplay between Return on Capital and valuation.  

 

It's the Long Term, Stupid

"In the long term, it's hard for a stock to earn a much better return than the business which underlies it earns.  If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return-even if you originally buy it at a huge discount.  Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive price, you'll end up with one hell of a result."

-Charlie Munger, Poor Charlie's Almanack

I think that this is one of the most powerful yet underestimated principles across all of investing literature and it makes me think that I should have probably started this post with it given its importance. The core idea is exceptional. Investors expend tremendous effort looking for businesses trading at discounts to intrinsic value to reap the difference between price and intrinsic value but Munger is saying don't waste your time trying to exploit these often minute differences. Because over the long term, businesses (and their stocks) will reflect their return on capital and the majority of the return on a given investment will be driven by this factor. Simple and brilliant.  

There are two additional points I would add here: 1) this only works if high returns on capital are sustainable - the company must be able to sustain its return on capital for long periods of time. This requires a high quality business that benefits from a durable competitive advantage and even then, it's not always a given that the company can maintain its returns; 2) Valuation is still important but it becomes less and less important as the holding period increases. If you are holding a stock for 1 or 2 years, then valuation is critical because the majority of return will be driven by the difference between price paid and intrinsic value. However, if you are holding a stock for 30 years, a discount or premium to value becomes insignificant as it gets spread out over many years. Base Hit Investing has a wonderful post explaining this very concept in more detail, which I'll also re-list below.  

 

On the Shoulders of Giants

I've only scratched the surface when it comes to ROIC. It's a powerful (although not perfect) metric that I could probably devote an entire book to if I had the time. Yes, ROIC isn't perfect and there are some shortcomings including consistency of calculation -you can find about a hundred different ways to calculate it, but there is no perfect metric so it's the best we've got.  There is a litany of writing about ROIC by people far smarter on the topic than myself. For those interested in digging a bit deeper into the nether reaches of ROIC, I thought that some of the best writing on the topic was worth sharing here. It's a combination of both technical posts on the calculation of ROIC and philosophical posts on ways to think about it. One of the posts emanated from a conversation I had with the fine gentlemen at Ensemble Capital.  I'll start there.

Intrinsic Investing Blog by Ensemble Capital

A couple months back - I had the opportunity to meet with Sean and Arif from Ensemble Capital - two very smart guys that manage and invest money with a philosophy that's not very different than my own - buying businesses with durable competitive advantages at a reasonable price, a concentrated portfolio of high conviction positions and a long term holding period. In addition to generating very respectable returns over the last ~15 years, they also pen an astute investing blog- Intrinsic Investing that I've followed for quite some time.  After talking at length about individual names, I was interested to hear more about how they think about ROIC - Sean kindly responded to some of those questions about ROIC that still keep me up at night in a very insightful post.

Base Hit Investing

Base Hit Investing is one of my my favorite investment blogs and John - the author- has penned a series of very insightful posts on ROIC.  

Damodaran Online

    Aswath Damodaran is an NYU professor and the guru of valuation.  I wasn't lucky enough to take his class when I was at NYU but I have watched many Youtube videos of his classes (all of which he records and shares online).  His book - The Little Book of Valuation- is on my reading list.

    Credit Suisse

    This is a research paper that I randomly came across online.  I thought it was a valuable instructional resource on ROIC.

    McKinsey Quarterly

    WSJ