Return on invested capital (ROIC) is one of the most important and overlooked matrix for management evaluation. Within a specific sector, many investors compare earnings, earnings growth, dividend, and yield. Some will scribble these numbers on the back of a napkin, others using spreadsheets. However, they may be missing an interesting fundamental comparison tool, especially in the capital intensive, low growth, and usually regulated environment of utilities.
The majority of investors should be familiar with return on equity (ROE) and this ratio is available as a standard analytic tool. Most financial reports and stock summaries will, as a minimum, list the trailing twelve month ROE.
However, if two similar companies generate the same return on equity, but one utilizes twice the debt capital, management should not be viewed as generating equivalent shareholder value.
ROIC evaluates company earnings to its total capital investment by combining both shareholder equity and total debt. The ability of management to produce profits from the available capital created through equity and through debt issuance gives a clearer picture of management effectiveness, especially in capital-intensive businesses. In general, some believe management should grow long-term earnings about in line with its multi-year ROIC achievements.
According to the Public Utilities Fortnightly, a utilities industry trade magazine, discipline in capital expenditures is the key to improving ROIC. Due to the combination of high capital expenditure needs and debt funding, better managers will utilize their available leverage to increase returns. According to the article, which focused on the top 40 public utilities, ROIC had a much higher correlation to 3-year total stock returns than either dividend yields or gross margins.
The problem with consistently using ROIC as a comparison tool is the complexity of the formulas and the lack of easily accessible presentations. Most company reports and stock summaries do not specifically offer a ROIC management effectiveness assessment. Rather than just looking up a number on a stock summary, ROIC evaluations sometimes have to self-calculated. Listed below is one of the most basic formulas:
Net profit (also called net earnings) divided by total investment (total debt plus total equity), then multiplying by 100 to arrive at a percentage.
All of the components of the formula can be found on the company’s income and balance sheets. There is also a more complex ROIC formula called the DuPont Formula that incorporates deployment of assets and cost controls. Further evaluating ROIC with management’s weighted average cost of capital (WACC), also known as the ROIC Spread, probably gives the truest picture of management’s financial performance.
Again, the problem is being user friendly. While the raw data is readily accessible, most investors overlook the need to actually do the calculations. It is also critical to have consistency in acquiring the data; such as does the net profit calculation include taxes and is it before or after special charges.
Years ago, I read an article that discussed an easier return on invested capital comparison using a formula that incorporates readily accessible ratios. While I am not a math whiz or an accountant (and I expect to hear a lot from them), the formula is easy to calculate and remember:
ROIC = Return on equity divided by (1 + total debt to equity)
While not as exacting as the actual ROIC formula, the modified version incorporates the amount of debt management utilizes. By using the same source for the basic raw data, consistency becomes less of an issue. For instance, the ratios used in the modified formula are available on Yahoo.Finance.
Morningstar.com offers their ROIC calculations equities they follow and is available in the “Key Ratios” tab of their stock summary report. Fastgraph.com offers interesting graphics of historical ROIC ratios by company through their premium service. Reuters.com offers trailing twelve month and 5-yr average ROIC on its “Financial” tab from its stock summary report page.
For example, AES Corp (AES) has generated a trailing twelve month ROE of 9.53% and is pretty close to American Electric Power (AEP) 9.48% ROE. However, AES carries a current debt to equity ratio of 2.73 compared to AEP’s 1.22. The return on invested capital ratio for AES would calculate to 2.55% compared to AEP’s 4.27%. Over the past 12 months, AEP’s management has generated a substantially higher return for shareholders based on all the capital at its disposal than AEP.
Applying the return on invested capital formula to the Dow Jones Utility Average stocks would produce the following table (Return on Equity - Total Debt to Equity Ratio - and Return on Invested Capital):
Dominion Resources (D) 16.67% 1.10 7.94%
Centerpoint Energy (CNP) 12.46% 1.93 4.25%
NextEra Energy (NEE) 10.10% 1.32 4.35%
AES Corp. (AES) 9.53% 2.73 2.55%
American Electric Power (AEP) 9.48% 1.22 4.27%
Consolidated Edison (ED) 8.80% 1.10 4.19%
NiSource Inc. (NI) 8.58% 1.50 3.43%
Southern Co. (SO) 8.40% 1.16 3.89%
Exelon Corp. (EXC) 7.70% 0.73 4.45%
Edison International (EIX) 7.70% 0.97 3.91%
Duke Energy (DUK) 6.45% 0.99 3.24%
PG & E Corp. (PCG) 5.43% 1.01 2.70%
FirstEnergy Corp. (FE) 2.91% 1.62 1.11%
Reviewing the same type of information for large-cap oil and gas exploration stocks would generate the ROIC comparison table below (Return on Equity - Total Debt to Equity Ratio - and Return on Invested Capital):
BP (BP) 19.00% 0.36 13.97%
Chevron (CVX) 14.98% 0.13 13.26%
Total SA (TOT) 11.62% 0.44 8.07%
Suncor (SU) 9.53% 0.27 7.50%
ExxonMobil (EXC) 7.70% 0.87 4.12%
Apache (APA) 6.86% 0.27 5.40%
There are many short-term factors that might constrain or exaggerate ROE figures and these types of ratios are best reviewed over time. Taking into consideration reduced demand in some economic sectors due to sluggish economic activity, returns for some companies over the past year have been lower than their historic average and should improve going forward. Keep in mind this is only a snapshot of management’s effectiveness today.
Adding a return on invested capital ratio to basic stock research may assist in identifying better quality management that could provide better shareholder returns. The more tools incorporated in research, the more prepared an investor becomes in making market-beating stock selections. The addition of one more column to the scribbling on the back of your napkin may prove to be enlightening.
Disclosure: I am long AEP, SO, EXC, APA, SU. These companies are followed by Guiding Maast Investments monthly newsletter.
I appreciate your time and interest in Guiding Mast Investments, George Fisher