In general, earnings growth drives stock prices higher. If investors are willing to pay 20 times earnings for a company, and company earnings grow from $5 per share to $6 per share, the stock price will increase from $100 to $120.
Earnings growth can be the result of a well-managed company, not the indication of a well-managed company. This means an investor needs to look at company fundamentals beyond earnings growth to determine the quality of the earnings. Return on invested capital is one of these key fundamentals.
Return on invested capital attempts to measure how effectively a company is managing its capital - the higher the return, the better the management. There are four “return on” fundamentals commonly reviewed:
- Return on Assets (ROA)
- Return on Common Equity (ROE)
- Return on Capital (ROC)
- Return on Invested Capital (ROIC)
The numerator in each calculation is some form of net income or operating income. This represents the amount earned from a given level of capital. The specifics of each denominator vary, but it attempts to capture the level of investment made in the company, i.e., the capital.
ROA: Assets are the cash, inventory, property, and goodwill on a company’s balance sheet. ROA attempts to capture how effectively a company is utilizing its assets.
ROE: Common Equity is assets minus liabilities, such as debt and accounts payable (cash owed to suppliers). It excludes minority interest and preferred equity. In theory, common equity represents what shareholders have invested in the company, as it is everything remaining after creditors are paid (liabilities owed). ROE then calculates the return on those shareholders’ ownership.
ROC: Capital is the total investment made by both shareholders and debt holders in a company. The denominator in ROC includes both common equity and preferred equity, as well as minority interest. It also includes total debt. ROC, therefore, calculates the return on the total investment in the company.
ROIC: Invested Capital includes everything in the above capital definition, plus deferred tax liabilities, accrued income taxes, and allowances for doubtful accounts. It consists of all money endowed to the company by shareholders, debt holders, and any other interested party. ROIC is, therefore, a more inclusive definition of capital.
How can ROIC help determine the quality of a company’s earnings? Consistently high ROIC is important. ROIC tends to vary by sector; for example, technology companies have a higher ROIC than financial companies. Companies with higher returns on invested capital compared to peers tend to generate higher quality earnings.
Consistency is equally important, as a company with falling ROIC may be making increasingly worse investments. For example, a company with $20 billion in invested capital and $2 billion in earnings has an ROIC of 10% ($ 2 billion/$ 20 billion). If that company acquires another company and invested capital increases to $30 billion while earnings grow to $3.3 billion, not only have earnings grown 65%, but ROIC increased to 11%. Now, let’s say the company makes another acquisition, and earnings grow another 50% to $5 billion. However, if after the acquisition, invested capital increased to $56 billion and, therefore, ROIC fell to 9%, the quality of the growth was not the same. While the company continues to grow, the returns are falling.
Investors may eventually note this, and perhaps they will not pay as much for the company’s earnings. Earnings may grow, but a contracting multiple can offset that growth. Of course, the opposite is true- higher ROIC may lead to a higher multiple. In conclusion, it’s always essential to understand what is driving the earnings growth.
For informational and educational purposes only. Opinions are subject to change.
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