The most commonly accepted metric to assess the effectiveness of a company’s management team is its return on invested capital (RoIC). Michael Mauboussin and Dan Callahan of Morgan Stanley are in their typically articulate form in this research paper showing how RoIC should matter for investors and businessmen alike.
They sum up the concept of RoIC as: “There is an old adage that you have to spend money to make money. Return on invested capital (ROIC) is one way to measure spending money (invested capital) and making money (net operating profit after taxes). ROIC, in turn, informs us about the value of a business, which is the present value of future free cash flows. Following the adage, free cash flow is the money you make minus what you spend to make it. The components of ROIC translate into the drivers of value.
A company creates value when its ROIC is in excess of its cost of capital. Stated differently, a company, through its activities, makes one dollar worth of investment worth more than one dollar in market value”
At the outset, the authors make an adjustment to the reported RoIC based on accounting norms. Mauboussin has been talking about how new age companies have very little ‘invested capital’ in the traditional sense i.e, land, factory, machinery, etc unlike traditional businesses. However, much of their value is driven of intangible assets such as brand, technology, distribution, etc which don’t get reflected in the ‘invested capital’ on the books of accounts. As a result, their reported invested capital and profit margins tend to be understated. Throughout the research paper, they make these adjustments to their analysis. Three things that stood out in terms of takeaways:
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