You receive a statement from the bank where your 100K is sitting in FD (fixed deposits). The statement shows that you earned RM3,000 on interest last year, and this year you earned RM3,090 or RM90 more. You are excited because the 'EPS(earning per share)' of your FD is 'growing' so you decide to put more money into it.

But you are not easily fooled. You realized you earn more this year because you reinvested all the interest last year. The fact that the bank still pays you 3% of interest for both years has not changed.

If a company earns the same return aka return on invested capital, ROIC for short (in FD example that's 3%) on 2 consecutive years but the EPS has increased, does that mean the stock has become more valuable (or become a hidden gem) & deserve a higher PE multiple?

If you feed a person enough food everyday, eventually he will become obese. Throw enough money into a business, the EPS almost always grows, but that doesn't mean the business is more valuable now.

You asked 2 friends how much their business is making a year and Ali told you he made $10,000 a year whereas Ahmad told you he made $100,000 a year. You don't want to talk to Ali already. Ahmad is definitely smarter and has a more profitable business. But Ali forgot to tell you he made that profit using $20,000 capital, a 50% return whereas Ahmad had to pour $1 mil into it, a return of 10%.

Return on invested capital (ROIC)
Hopefully now you understand that looking at EPS growth only gives you a small snippet of the big picture. It is like telling your friend you ran at the park for an hour yesterday but leave out the key part “Was that 1km or 10km?”.

Share price is driven by value creation. And value creation is the principle where companies can create value by investing capital to generate future cash flows at the rates of return higher than the cost of capital.

“At the rates of return higher than the cost of capital” - This sentence differentiates and explains why companies like Wellcal is selling at 8x book value and Hartalega at 5x while Leon Fuat and Khind have persistently sold below book.

When companies use the money from shareholders (in the form of equity) and banks (borrowings) to grow their business, shareholders demand a satisfactory return for their money, that’s the cost of capital. Or they will ask “If this business only gives me a return of 3% a year I might as well put it in FD that carry a lower risk?”

Investors are willing to pay a premium for Wellcal or Hartalega and the likes because they have proven that they can generate a return above the cost of capital. ROIC is a critical metric to find out how efficient a company can generate returns from its capital.

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Return on Invested Capital (ROIC) = 
Net Operating Profit After Tax (NOPAT) / Invested Capital (IC)

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Source: Valuation: Measuring & Managing the Value of Companies

Exhibit 2.5 shows that a high ROIC company can create more value by focusing on stronger growth whereas moderate ROIC company should focus on improving ROIC before growth. Although the exhibit used packaged-good company and retailer as example but the idea behind applies to all industries. The rational is that if a company’s long term ROIC is below cost of capital, growing the company will only destroy shareholders value. Thus all effort should be put on increasing profit margin and asset turnover, the 2 drivers for ROIC.

Source: Valuation: Measuring & Managing the Value of Companies

Exhibit 2.4 explains this further. The figure inside the box is the value of the business. With cost of capital at 9%, any ROIC below that (in this case 7% ROIC) destroys value the faster a company grows. That’s why some stocks sold below book. If a stock manage to get a return the same as cost of capital, it doesn’t matter how fast the growth in EPS is, the value remains the same.

For calculating cost of capital, you can either use Capital Asset Pricing Model (CAPM) or for simplicity sake, use 10% for all stocks. ROIC for most companies range between negative to +40%, trying to find out whether the cost of capital is 8% or 9% is not going to make much of a difference.

You know ROIC is the key driver to value creation, should you start heading out there and buy up all high ROIC stocks? A company’s ROIC is not a secret; everyone knows it, that’s why the price of Wellcall or Hartalega have been bidden up to reflect its future prospects. Therefore, it is unlikely to give you an above-average return. Or worse, you might actually underperform.

Say you are a great chef. Whenever you cook for your diners, they would expect nothing less but the best quality food from you and your restaurant. After a while it becomes a challenge to surprise them because your culinary skills are already at the very top. The room for improvement is limited.

Many great companies with high ROIC encounter the same scenario. The market pays a premium and expect nothing less but great future growth and outstanding ROIC. It is hard to surprise the market when you are the leader in the industry. As an investor you will earn an average market return if all goes well. If there’s a speed bump – a soft economy; a failed overseas expansion; a fumbled acquisition etc you are very likely to suffer a large downside. And this is to the contrary belief that quality stocks are defensive.

As the saying goes “You don’t get paid finding the best horse, you get rewarded for finding the horse that’s been mispriced by the market”. Stocks that will earn you above average return with minimal risk (asymmetrical return) are the ones where there’s a big gap between price and the fundamentals. Good companies hitting speed bump or problematic stocks are all hotbed for the mispriced.

When you shift your attention from EPS to ROIC you begin to get a good idea why some stocks command a premium price while others don’t. Combine that knowledge with the understanding that most money are made from low expectation (the chef) and mispriced stocks, you can improve your chances of getting a better return by asking the right questions.

Instead of predicting where EPS will be next quarter try figure out if ROIC will improve. You can correctly predicted EPS yet fail to be rewarded. Try asking what’s the cause of falling profit margin? Is it likely to be temporary or permanent? How about asset turnover?

Conclusion
ROIC is the main driver that determines the value of a company and ultimately its share price. EPS is important but it doesn’t tell you how efficiently the company utilizing its capital. Compare the return (ROIC) of a company with its cost of capital to determine if the company is creating or destroying value.

If premium has been built into the share price of high ROIC stocks, it is unlikely you will earn above- average return. The key is to find stocks that have been mispriced by the market. By spending your time to understand how ROIC will change over time can improve your chances of earning asymmetrical return.

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