Comparing companies with ROIC: A case for Pintaras Jaya kcchongnz

"The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine."
-- Warren Buffett

In my previous post  below, I used the return on equity (ROE) to compare the performance of two companies in the similar industry, Pintaras and Kimlun. We found that Pintaras at a ROE of 19.4%, it is far better than the 12.1% of Kimlun.

http://klse.i3investor.com/blogs/kcchongnz/49969.jsp

ROE is an easy-to-calculate and a good tool that helps to measure a company's ability to earn returns on shareholder capital, if it is consistently high, and how is it when compare with its peers. It is especially useful to compare financial service firms, such as banks and insurance companies. I have in fact use ROE to value their stocks based on the following formula:

Fair value of stock = ROE/Required return * Book value

ROE has proven enduring. At one level, this makes sense. ROE focuses on return to the shareholders of the company. If you are a shareholder, this gives you a quick and easy to understand metric.

But ROE can obscure a lot of potential problems. Companies can resort to borrowing more money to artificially maintain a high ROE — for a while — and hide deteriorating performance in business fundamentals. At the same time, it can subject the company to the risk of bankruptcy during a financial crisis. Excessive leverage, or borrowing too much can cut both ways. Hence I often advocate the use of another metric, return on invested capital (ROIC) as a measure and comparison of efficiency.

What is ROIC?

ROIC looks at all the money invested into the company, both by shareholders and lenders, to measure how well management uses all that cash to generate profits. It is calculated as net operating profits after taxes (NOPAT) divided by invested capital. 

ROIC = NOPAT / IC

NOPAT = Earnings Before Interest & Taxes (Ebit) * (1 - Tax Rate)

IC = Net operating working capital + Property, plant and equipment

We need to measure ROIC against weighted average cost of capital (WACC) since WACC is the minimum rate of return that a firm needs to earn for its stakeholders. 

Re = cost of equity

Rd= cost of debt

E= Market value of equity

D= Market (or book) value of debt

V = E + D

Tc = corporate tax rate

One thing to look for is that when ROIC is greater than WACC, value is being created for the stakeholders.  When this ratio is less than WACC, value is being destroyed.  On very broad terms, a firm with a higher spread between ROIC and WACC tends to be more valuable than a firm with a lower spread.

Pintaras Jaya and its ROIC

The following Table 1 shows the computation of ROIC of Pintaras for its trailing twelve month results for 2014, and its comparison with Kimlun.

Table 1:

The computation shows that the ROIC of Pintaras is 35%, more than three times its WACC, which is the required return of equity shareholders, as it has zero debt. My required return in investing in Pintaras is 10%, a relatively lower value as it has stable earnings and cash flows. How is it compared to its peer, Kimlun?

Kimlun has a market capitalization of RM414m at RM1.72 at the close on 11^th April 2014. It has a total debt of RM235m in book value. Hence its WACC is 9.0%, assuming cost of equity at 12%, cost of debt 5%, and a tax shield of 25%.

Hence ROIC of Kimlun is still good at 17% as it is way above its WACC. It can be said that Kimlun has cleverly utilize debts to enhance its return of capital. It is just a little risky with the debt about 0.8 times its equity, especially when the economy turns for the worse, or a looming financial crisis. However, when compared with Pintaras, its ROIC is far behind.

It is clear that Pintaras financial performance is far better than Kimlun, both measured in ROE and ROIC. However, we still have to determine the price we have to pay in order to decide which company is a better investment.

K C Chong (12^th April 2014)