Modern Value Investing: Return on Invested Capital

How ROIC is important in its own right, and in establishing intrinsic value

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Jan 17, 2019
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Is return on invested capital the big fish in the investing ocean?

Charlie Munger (Trades, Portfolio) thinks as much, and Sven Carlin follows Munger as he discusses this metric in “Modern Value Investing: 25 Tools to Invest With a Margin of Safety in Today's Financial Environment.”

Tool 7: ROIC

As Carlin put it, Munger is known for having a “simplistic” view of investing, but that view has served

Warren Buffett (Trades, Portfolio)’s partner very well. He has a 50-year track record with an average annual return of 19%. Carlin added this Munger quotation: “It’s obvious that if a company generates high returns on capital and reinvests at high returns, it will do well. But this wouldn’t sell books, so there’s a lot of twaddle and fuzzy concepts that have been introduced that don’t add much.” (Note: return on invested capital and return on capital (ROC) mean the same, and often are used interchangeably.)

Returning to the ROIC metric, the author wrote that this shows how well a company is applying the capital available to it. It is calculated with this formula:

  • ROIC = net income / capital (equity plus long- and short-term debt)

He further noted there are some variations of the formula; for example, some exclude taxes and interest expenses from net income, but he preferred the basic formula. Carlin then set out to calculate and compare the ROIC for The Southern Co. (

SO, Financial) and Apple Inc. (AAPL, Financial) to illustrate its importance.

In the tables that follow, he arrived at net income by using the average net income over the previous five years; debt and equity came from the balance sheet, and he made no adjustments in preparing these tables:

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As the tables show, Apple’s ROIC is almost 10 times greater than that of The Southern Co. He observed Munger would argue these results would produce similar long-range ROIC figures, and would likely be right. Apple has averaged close to 20% in average annual returns over the past 10 years while Southern’s have been around 2% (dividends excluded). The difference is dramatically illustrated when the results are charted:

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This backs up the Munger argument laid out above, in showing that a high return on capital, plus reinvesting retained earnings (Apple long resisted paying dividends), will lead to high returns in the long term.

Speaking of long term, Munger has said that in the very long term, return on capital determines what the stock will provide, regardless of the current discount. There might be differences based on when an investor bought Apple: $28.30 in 2008 or $12.90 in 2009. But investors who bought at either price should be happy today: The price on Jan. 17, near mid-day, was $158.35.

Carlin explained that use of ROIC for assessing investments implies two things:

  1. You have a long-term perspective, allowing you to ignore the market noise while knowing that stable and high ROIC provides assurance that a permanent loss of capital is unlikely.
  2. You screen many investments to find the best one, which will have above-average returns on invested capital, be priced fairly and have a sustainable high return because of a strong moat.

He went on to say that if the price of the chosen stock falls, a shrewd investor will buy more and “Such a strategy has made both Buffett and Munger billionaires, it might make you at least a millionaire if not more.”

ROIC is also essential in establishing intrinsic value. More specifically, Carlin argued it is one of three components of intrinsic value:

  1. Current book value, adjusted for dividends and historical cost accounting issues, provides the amount of value created in the past and into which investors are now buying.
  2. Current earnings, which equal the change in book value, show how much value is being created at the time investors are doing their analyses.
  3. Return on capital will set investors’ expectations for the future since it provides an estimate on the amount of value that will be created in the future.

The three components, then, allow investors to sum up past, present and future valuations, and provide a reasonably objective intrinsic valuation at a particular point in time.

But Carlin wants to go deeper still. Actual intrinsic value, he said, depends on investing preferences, referring to expected rates of return. In the long term, investors can expect their returns will be perfectly correlated with business earnings.

However, improvements are available when the market is irrational and has underpriced the assets in terms of business earnings. For example, investors seeking a 10% return would calculate their intrinsic value using a multiple of 10 on current and future earnings. Stocks available below that intrinsic value would then be a buy.

These types of situations may be found where capital is being invested with no payback for a few years, such as new hotels, pipelines and mines. Carlin pointed out such projects are often discounted at a higher rate than normal, thus creating good opportunities for patient and intelligent value investors.

Summing up, Carlin wrote, “Now, you might or might not agree with Munger and Buffett as they evolved from the pure value investors they had been in their youth, but return on capital is one of the most important metrics when investing and is crucial to intrinsic value.”

(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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