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:
- Change in RoIC drives shareholder returns: The authors show that the market does a good job of appreciating the quality (high RoIC) of companies and valuing them. Hence, what drives returns is the change in RoICs: “Rising ROICs tend to be good for shareholders and falling ROICs tend to be bad. For example, companies that started in the bottom quintile and ended in the top one (bottom left corner) generated TSRs of 33 percent. Companies that started in the top quintile and ended in the bottom one (upper right corner) generated TSRs of -11 percent.”
- Mean reversion and persistency: The authors show that whilst at the market level RoICs tend to move towards the mean thanks to competitive forces, certain sectors show a lot of persistency in RoICs and hence valuations and returns, thanks to sustainable competitive advantages. “Companies commonly end up in the same quintile in which they started, but those that meaningfully change their ranking often provide opportunity for outsized returns.”
- Drivers of RoICs and competitive strategy: The two drivers of RoICs – invested capital turnover (sales per unit of invested capital) and net profit margins (profits per unit of sales) reflect two competitive strategies – cost leadership and net profit margins. “…we looked at companies that delivered high and sustained ROICs and found that while they exceeded their peers in both NOPAT margin and invested capital turnover, NOPAT margin was a significantly more important driver. This suggests that companies that pursue a differentiation strategy have been more represented among companies delivering superior returns over time.”
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