Return On Invested Capital (ROIC) measures the levels generated by each dollar of capital invested in a company's operations and how profitably management is able to allocate capital to generate cash flow over its weighted cost of capital (WACC).

ROIC-WACC spreads are KEY to value creation. Firms whose ROIC exceed their WACC generate positive net cash flow, creating value; while a company whose ROIC equals its WACC neither creates nor destroys value.

Generally, companies with higher ROIC-WACC spreads are more valuable and command higher multiples.

If a company is selling for, or below, book you can be fairly sure it has not earned its WACC in the recent past.

Firms can create value by one of three avenues:
1. Reallocating/improving use of existing capital to increase the spread.
2. Deploying more invested capital into current operations or investing in new projects provided returns generated by either generate marginal ROIC in excess of WACC.
3. Lowering their WACC.

CAN YOU SEE THE FIRM YOU ARE INVESTING IN DOING THIS? AS THIS WILL BE KEY TO CREATING SHAREHOLDER VALUE!

Increasing industrywide and extraordinarily high ROICs are hallmarks of young, strong and growing sectors. In contrast, sequential declines, or marginal ROICs below historical ROIC (barring seasonal factors), may indicate a mature industry where long-term investment opportunities are waning.

Consistently high ROIC-WACC spreads generally equate to the 'moats' that many investors seek. One very rough way of gauging a 'moat' would be to look to see whether a company maintains a high ROIC-WACC spread for several years.

Again, as a rough rule of thumb, WACCs for most U.S. companies range between 9-13%, so ROICs consistently in the mid to high teens allude to something Moat-like and worth digging into.


PROBLEMS WITH ROIC IN GENERAL
ROIC solves some of the P/E ratio's pitfalls, particularly, PER fails to illuminate whether firms are producing value, or how much capital firms consume to produce earnings. But like all metrics ROIC has its pitfalls.

First off, you obviously need to monitor the trend. ROIC in the high teens may be great, but less so when its come off a base in the 20% range.

More critically, ROIC can be problematic for companies with very low invested capital bases. E.g., companies that outsource production, like software development firms, and most services firms, like advertising agencies, will have very low invested capital bases.

McKinsey & Co. point out for companies with invested capital below 25% of revenue ROIC may not be a fantastic benchmark as small changes in capital requirements can cause the ROIC to be both very large and volatile from period to period.

Some solutions would be to;
1. Normalize capex over a period to smooth out volatility
2. Or not use ROIC altogether, McKinsey offer an alternative calculation for those interested, in the above link.

It is also not helpful to compare ROIC across industries. In 2004, system software development companies' median invested capital as percentage of revenue was -3% compared to 163% for hotels, resorts and cruise liners, according to McKinsey.


ROIC CALCULATION
There are two equations used for calculating ROIC that I have seen used most frequently:

1. The standard ROIC formula
Net Operating Profit After Tax/ Average Invested Total Capital

2. The Greenblatt Method
EBIT/Net Working Capital + Net Fixed Assets

I'm going to focus on the second method in my next post as it seems to have captured value investors' attentions recently. Handily, the Greenblatt method is, I think, more intuitive than the traditional method and easier to calculate.