Over the long-term, an investor’s primary focus should be value creation, how much value has been and will be created with the funds invested in and deployed by the selected company. This applies to both value and growth investors.
Return On Invested Capital (ROIC) is a superior guide with which to assess value creation. Indeed, ROIC can be significantly more informative than traditional investment performance metrics such as EPS, EBITDA, and ROE, all of which can be manipulated and misleading.
A brief reminder: ROIC measures the amount of cash generated by each dollar of capital invested in a company’s operations. A company whose ROIC exceeds its cost of capital generates positive net cash flow, thereby creating value; a company whose ROIC is less than its cost of capital generates negative net cash flow from an economic perspective, thereby destroying value; and a company whose ROIC equals its cost of capital neither creates nor destroys value.
The ideal value-creating company is one that can achieve an ROIC that exceeds its cost of capital, and can reinvest cash flow back into new investments, with similar traits. The larger the positive spread between ROIC and cost of capital, the longer the spread can be maintained and the company and the more capital that can be invested in the company’s business, the greater will be the net positive cash flow generated by the company.
“While the positive spread between each investment’s ROIC and corresponding cost of capital ideally should be equal to or greater than the spread between the company’s current ROIC and cost of capital, each investment will create value as long as its spread is positive, regardless of the size of the spread. If a company’s cost of capital exceeds its ROIC from current and prospective investment projects, however, any growth will transfer value from the company’s investors to its customers, suppliers, management and/or employees.” — A New Way to Listen to the Music: ROIC, Robertson Stephens & Company.
An analysis of ROIC can provide an early warning system to investors. Analysis of the level of marginal or incremental ROIC relative to historical ROIC, along with an analysis of the change in the level of sequential ROIC quarter-over-quarter and year-over-year for individual companies and industries as a whole can provide an early warning system of shifting dynamics for investors.
Extraordinary levels of ROIC are the hallmarks of an industry that is young and growing, or of an industry that has high barriers to entry with a steady outlook for growth. Companies that meet these qualities are usually rewarded with high P/E valuations. (Company that consistently earns an ROIC in excess of the industry average and that is able to maintain or increase the level of its ROIC typically deserves and is rewarded with a higher market valuation than its peers.) In comparison, a declining ROIC may indicate that the long-term investment opportunities in the industry are dissipating — a sign of a maturing industry.
If you’re looking for evidence to support this fact, look no further than Tesco, the UK’s largest retailer and the world’s third-largest retailer by sales.