The Importance Of Return On Capital

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One grossly over-looked factor in investing is Return on Invested Capital, or ROIC for short.

In business, ROIC is everything. It is a measure of how efficiently a company employs its resources to generate profits or, more importantly, free cash flow.

But ROIC is rarely a prominent statistic on any financial websites (except this one). Many stock traders have no idea what it is. It is doubtful your (or your parent's) money manager knows what it is or uses it. When is the last time you heard about ROIC on CNBC? It's rare.

It's time to change that. In this article, we will dive more into return on invested capital, examine what it is, how you calculate it, and why it is so important.

What the Heck is ROIC?!

Lets start with the most obvious question - what exactly does return on invested capital mean, and what does it tell us?

An analogy may be the most apt way to grasp it. Imagine you are an investor, shopping for a mutual fund in which to park your hard-earned savings. Since you are investing for the long term, you leaf through prospectuses looking over the 10-year average returns. Fund A has delivered 15% annual gains to its investors, while fund B has delivered just 5%. Clearly, your money would have grown faster by being in fund A. The fund manager there better allocated the dollars under her control to achieve wealth for her investors.

The concept is no different if you replace "mutual fund" with "business". Management has to decide how to allocate their capital, including equity capital (earned through the issuance of shares to the public), debt capital (acquired through bond issuance or bank loans), and operating earnings (earned through operations). The decision has to be made - do I spend to grow sales organically, for example by spending on product development or new sales territories? Or do I pay to acquire new business lines? Or are growth opportunities limited and acquisitions overpriced enough that I should just sit on my cash or pay it back to shareholders? These decisions are at the core of senior management, and the effectiveness of these decisions are reflected in the return on capital number. A business with a higher return on capital, like a mutual fund with a great manager, will deliver more wealth to its shareholders over the long term.

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