When it comes to picking the best stocks, there are dozens – perhaps even hundreds – of metrics an investor can use for analysis. Many novice traders simply use the price-to-earnings ratio (PE) to compare stocks for their portfolios whereas some consider ROE to be a prime decision-making tool. Others go a step further and determine the free cash flow to a firm in order to find out how much money the company is generating. However, no discussion of important investment metrics would be complete without mentioning the Return on Capital (ROC). Every good business has to generate high returns on capital consistently because it is the fundamental driver of valuation.
High ROC over a period of time is a good indicator of identifying businesses with competitive advantages. There are several variants one can use to calculate ROC. In all cases, the measurement looks to capture the level of profits of a company expressed as a percentage of invested assets or capital. However, one of the most effective ways is to calculate the Return on Invested Capital (ROIC). Despite being one of the most reliable performance metrics for spotting quality investments, ROIC doesn’t get the same level of interest as compared to popular metrics like PE or ROE. This is simply because investors cannot pull off this metric from a balance sheet like they can with other popular ratios.
It requires some degree of understanding and a little calculation. However, for those eager to find out the true value a company is generating, calculating ROIC can be well worth the effort:
ROIC = NOPAT / Invested Capital
here, NOPAT = EBIT (1 – Tax Rate)
And, Invested Capital = Net Working Capital + Net PPE + Other Operating Assets – Excess Cash.
This story is from the January 20, 2020 - February 02, 2020 edition of Dalal Street Investment Journal.
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This story is from the January 20, 2020 - February 02, 2020 edition of Dalal Street Investment Journal.
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