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Return on invested capital (ROIC), a key indicator
Fri, 10/07/2016 - 10:06

Andrés Cardenal

Tres compañías tecnológicas con sólidos dividendos
Andrés Cardenal

Andres Cardenal es Analista de Sala de Inversión América.

Return on invested capital or ROIC, for its acronym in English (Return On Invested Capital) is one of the most important indicators that we can take into account when selecting stocks. What is this ratio and how is it interpreted?

There are different methods to calculate ROIC, and some analysts often apply particular considerations when analyzing business numbers. However, the central point is that it is a measurement of the company's ability to generate profits for each dollar of invested capital, which includes both shareholders' equity and financial debt.

In its most traditional version, the ROIC ratio is calculated by taking after-tax operating profits and dividing them by invested capital. The ratio is expressed as a percentage, and then demonstrates the company's profitability on the money it invests.

The numerator in the equation, operating profits before taxes, takes the profits that arise solely from operating the business; Results from financial investments or issues related to extraordinary profits during a given period are not included.

A good deal of self-analysis is required to determine which expense and income items should or should not be included, since after-tax operating profit is not routinely reported in companies' financial statements. This implies a necessary degree of subjectivity, which is why it is important to pay attention to the assumptions behind the ROIC calculation for each company.

Regarding the amount of capital invested, the value of the assets is generally taken, discounting some specific items, such as surplus cash if it exists, or financial investments. The objective of these adjustments is that the capital measurement incorporates only those items that are necessary for the operation of the business.

When calculating the ROIC, the numerator and denominator are intended to be consistent with each other. Since only the operational results of the business are considered in the numerator, capital measurements also incorporate only those items that are necessary from an operational point of view.

As can be seen, calculating the ROIC ratio is much more complex than using other traditional profitability measures, such as return on equity or return on assets. The main difficulty lies in the fact that the ROIC formula requires certain adjustments and a considerable degree of subjectivity, since the analyst must decide which values to discount, both in the income statement to calculate the operating profit before taxes and in the company balance sheet to obtain the invested capital.

On the other hand, the flip side of this greater difficulty is that the ROIC ratio provides greater precision and results in a more transparent measure of the profitability of the business. Ultimately, what we are most interested in knowing as shareholders is the level of profitability that the company can consistently generate based on its operations, and in this sense the ROIC ratio is an enormously valuable tool.

Using the ROIC ratio for decision making. It is easy to understand that ROIC has a positive impact on shareholder return. Assuming everything else remains the same, the investor should always choose the companies with the highest ROIC, since these are businesses that have a superior ability to generate profitability based on their capital. Needless to say, the more profitable the business is, the more valuable it is to the investor due to its potential to generate profits based on the capital invested.

With this in mind, investors generally compare a company's ROIC ratio with that of other companies in the same sector, as well as the evolution of ROIC over time to evaluate trends in business profitability levels.

A central point is to pay close attention to the sustainability of profitability levels and what this tells us about the quality of the business. In general, for a company to be able to sustain an ROIC ratio above the industry average, it must have competitive advantages that differentiate it from the competition, such as a valuable brand or scale advantages.

Some firms in businesses such as technology or pharmaceuticals typically generate high levels of ROIC over a given period. Over time, competitors develop similar technologies, or competitive pressure increases when patent protection on medicines expires. In these cases, it is common for there to be a sharp deterioration in profitability levels, which is generally accompanied by negative returns for investors in this type of company.

The ROIC ratio tells us a lot about the quality of the business; however, as with other financial indicators, it is crucial to understand the sources of this profitability and, above all, whether or not the company is in good condition. to sustain its profitability in the future.

*This column was originally published in Sala de Inversión.