Using return on invested capital as a valuation tool
Beginner Stock Market Investing, Stock Market Investing Advice, Stock Valuation
Return on invested capital [ROIC] is a technique that is used in forecasting the financial performance of a company. Many shrewd analysts believe that examining the true economic earnings of a company after deducting a charge for the cost of capital is far superior to restricting yourself to just the growth in earnings. You get a much better picture of the true value of the company in this manner. This is because the growth in earnings often comes at a price such as increased investment in fixed assets and working capital or the issuance of additional equity for expansion or merger and acquisition activity.
It is as important to understand how ROIC works as it is to learn how EPS is calculated or the significance of a PE ratio. At the end of the day, it is not the margin of profit alone that determines how valuable a company is but also the cash that is generated for every dollar that is invested by the shareholders or the creditors and the lenders. ROIC seeks to establish the true cash return on the resources available to the company.
In a sense, ROIC is similar to Return on Equity [ROE]. As you will know, ROE is calculated by dividing the net income for a given timeframe by the shareholders equity that has been used for this duration. A major drawback of the ROE calculation is that it uses only the figure for net assets. As you might know, certain items on the balance sheet which have to be shown as liabilities and hence sources of funds because of these standards laid down by GAAP [generally accepted accounting principles] actually have the effect of reducing the resources available to the company in the ROE calculation. In many circumstances, these liabilities should actually be seen to increase the resources of the company. ROIC is therefore superior because it reduces the amount from the liabilities and adds it to the equity. As a result, the ROIC figure would be lower than the ROE figure and more accurate.
It is clear from this that the understatement of resources in a balance sheet prepared according to GAAP may have the effect of overstating the return on equity causing analysts and investors to be misled about the value of the company. Another problem with ROE is that a return of say 15% on equity might be acceptable but may not look as good if you consider all the capital that is invested in the company including debt. There are several different ways in which the capital employed can be worked out.
The easiest way of doing this is to look at the total on the liabilities side of the balance sheet [after all liabilities represent sources of funds]. This figure is then adjusted to exclude sources of funds that have no cost such as trade creditors because they do not need to be serviced from earnings. This is different from the ROE calculation because only the return on equity after taking into account the cost of non-equity sources of capital is important.
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