Return on Invested Capital (ROIC):

"Leaving the question of price aside, the best business to own is one that over an
extended period can employ large amounts of incremental capital at very high rates
of return.  The worst business to own is one that must, or will, do the opposite - that
is, consistently employ ever-greater amounts of capital at very low rates of return."     
-Warren Buffett, 1992 Chairman's Letter


Return on invested capital (ROIC) is the ratio of after tax operating profits
earned divided by the amount of capital invested in core business
operations.





where:

Operating Working Capital equals operating current assets minus
operating current liabilities.

Operating current assets are current assets needed for core business
operations, including inventory, accounts receivable, prepaid expenses
and operating cash. Operating cash is the minimum amount of cash that
should be kept on hand at all times to give the company the flexibility to
meet unplanned cash shortfalls. The proper amount of operating cash
varies by business and industry, however, 4-5% of sales is appropriate
for most businesses.

Non-operating current assets are those assets classified as current, but
are unused in core operating activities. These include excess cash and
holdings of marketable securities. Excess cash is generally a temporary
imbalance and is not expected to earn a return, therefore, it is excluded
from the operating capital base.

When companies hold securities that represent partial or complete
ownership of an affiliate or strategic alliance, more often then not, these
assets should be included in invested capital. These securities tend to be
held on a long-term or permanent basis; the economics of the particular
relationship between the entities determines if such securities represent
capital invested in operations.

Operating subsidiaries are often referred to as "equity investees" or
something similar. Whatever language is used, it is critical to maintain
consistency between numerator and denominator; if an asset is included
in invested capital, the income accruing thereto must be included in
NOPAT.

Operating current liabilities are non-interest bearing current liabilities
necessary for operations. These are usually related to suppliers,
employees and customers; e.g., accounts payable, accrued salaries and
deferred revenue. Theoretically these items are the economic equivalent
of interest free loans made to the company by the related party. If the
company generates ample cash flow and can maintain proper liquidity,
the funding of working capital via non-interest bearing liabilities is
advantageous insofar as the company's own capital contributions will be
lessened.

The book value of property, plant and equipment, net of cumulative
depreciation, is always included in invested capital.

[Goodwill may be included or excluded from invested capital. It is
recommended to calculate ROIC with and without goodwill, giving
appropriate weight to each.]  -- (Include or exclude)


ROIC: Better Than Other Return Metrics

ROIC measures the efficiency with which capital is employed and places
a business's ability to create value from operations in perspective. The
metric blends profitability and capital efficiency, expressing operating
profit earned per dollar of invested capital.

For evaluating operating performance, ROIC is superior to more
commonly used return metrics like return on assets (ROA), and return on
equity (ROE). These return metrics are easily skewed by items and/or
financing decisions that do not influence true operating performance.

First, ROA includes the income from, and capital invested in, items
unrelated to core business activities. While it is true that non-operating
items may impact a company's value, sometimes dramatically, significant
non-operating considerations should be temporary and are generally
easier to value separately from core results.

Second, ROE is influenced by the company's capital structure. Even if
operating results for a period are poor, ROE can be artificially enhanced
with the use of excessive debt. In this way ROE can be very misleading
when it is studied only at face value. Trusting a high ROE as a sign of
good performance, without considering how heavily the equity capital is
leveraged, is always dangerous. A highly leveraged company may face
insolvency from only a small and temporary reduction in revenues.
(Essentially good ROIC is equivalent to good ROE that is not excessively
leveraged).

ROIC remedies these shortcomings by measuring returns against a
blanket measure of funds provided. Invested capital encompasses the
capital contributions of all investors unsegregated between debt and
equity; NOPAT is the effective return the company earned for all
investors. When calculated correctly, ROIC yields an unbiased measure
of performance and a fairly objective medium for comparing operating
results among companies of different size and/or capital structure.
Essentially, ROIC evaluates performance by measuring returns on a
hypothetical all-equity, or unlevered, capital structure.

Interest expense is really the return earned by creditors; this return must
be accounted for in NOPAT. Since interest payments are a tax deductible
"expense" the associated tax shelter must be added back in the
calculation of operating taxes. Taxation arising from non-operating
income are excluded from operating taxes.

Economic value is created for investors so long as ROIC exceeds the
market determined opportunity cost of capital. If the company's securities
are priced efficiently they will sell at a premium (or discount) of invested
capital commensurate with the ROIC-opportunity cost spread to be
achieved in the future.

Analyzing ROIC

ROIC analysis can provide quantitative evidence of factors otherwise
difficult to measure. Very high and sustained operating earnings relative
to capital employed is prima facie evidence of a strong franchise with a
competitive advantage.

Buffett has alluded to the importance of this metric a number of times. In
his 1977 chairman's letter, he states that businesses typically add to their
equity (capital) base on a consistent basis; he is therefore unimpressed
by a firm that increases its capital base 10% and its EPS by 5% then
claims "record profits". "After all, even a totally dormant savings account
will produce steadily rising interest earnings each year because of
compounding."

In his 1987 chairman's letter, clear logic is provided for the importance of
ROIC in determining business value. He asserts that viewed by itself,
operating earnings describe little in terms of economic performance. "To
evaluate that, we must know how much total capital - debt and equity -
was needed to produce these earnings."

The ROIC a business achieves over time is influenced simultaneously
through its own competencies and the competitive landscape in which it
operates. A mediocre business can generate high ROIC for a short
period; however, newfound success tends to breed newfound
competition. Only the truly outstanding business, backed by an
identifiable competitive advantage - or economic moat - can sustain
excellent ROIC in the presence of strong competitive forces.


Qualitative Aspects of ROIC and Competitive Advantage

As mentioned above, if a company is to sustain above average ROIC for
any significant length of time, it must have certain favorable qualities or
competencies that give it an advantage over competition unless overall
industry competitiveness is weak. It is essential to have a grasp on the
qualitative aspects of the business - it's competitive position and overall
strategy - because these conditions are usually epitomized by the future
ROIC.

Economic theory suggests that any business currently enjoying
abnormally high returns can expect competitors to enter the industry and
attempt to capture "excess returns". Once enough players are in the
game, no one in the industry earns return greater than the opportunity
cost of capital.

The exception is when a firm has successfully separated itself from
competition with an ‘economic moat’, designed to protect its business
from invaders. To justify a high and sustained ROIC, especially when
forecasting future performance, you must identify at least one
competitive advantage.

Broadly speaking, a competitive advantage will fall into three main
categories:

1) Price Premium

Companies that compete in commodity type markets are known as "Price-
takers". Their customers base buying decisions almost exclusively on
price. By definition, price-takers have little or no input in the price they
charge. In contrast, "Price-setters" are companies that offer differentiated
products, or products of superior quality, whose customers willingly
accept the higher price tag relative to substitutes.

Price-setting companies tend to have rock solid brand names that
consumers instantly identify with quality. The "share of mind" these
companies enjoy give them pricing power - the ability them to charge a
higher markup over production cost without significantly diminishing
demand.

Product quality and differentiation can come via proprietary technology,
patents or added features and reliability that competitors simply can’t
match. Also, products symbolic of status tend to garner premium prices
(e.g., Rolex, Mercedes-Benz etc.)

Just because a firm is able to command premium pricing today, does not
ensure it will enjoy this luxury next year, or even next month. To be
confident of sustained premium pricing the firm must constantly work to
"widen its moat". Perhaps more importantly, there must be a degree of
stability in the industry. For example, consider two companies with
significant pricing power: Coca-Cola and Microsoft.

It is pretty safe to assume the soft-drink industry will look quite similar 50
years from now as it does today. The industry will be larger, population
growth and globalization will take care of that; but you can bet there will
be no major groundbreaking advances in the product itself. The same
can not be said about the software industry. Coke’s ability to keep its
position as industry leader and retain pricing power over the long-term
looks much better than Microsoft’s.

This is what Buffett means when he says he needs to understand the
business before he can commit capital. There is no question about
Microsoft's current dominance in their industry; the question is what is the
length of their competitive advantage period? Not an easy one to answer.

2) Cost Competitiveness

The ability to maintain total unit costs below those of competitors is a
second determinant of competitive advantage and high ROIC. Wal-Mart
has achieved excellent returns on capital (in spite their massive capital
base) for many years due largely to its highly advanced system of
monitoring and controlling costs. As the largest retailer in the world, Wal-
Mart has favorable relations with suppliers and enjoys significant
economies of scale by virtue of massive purchasing volume. Also, the
company's sophisticated distribution system creates further cost savings.

3) Capital Efficiency

The third source of competitive advantage is the ability to earn higher
returns per dollar of invested capital than competitors; stated in terms of
the ROIC ratio, capital efficiency is improved by lowering the denominator
without lowering the numerator commensurately.

Dell, for instance, has championed of the capital efficiency advantage.
The company’s business is built around direct selling through its online
ordering system. The company operates a minimal property account and
much of its working capital is financed by suppliers and customers,
meaning it receives payment from customers before it pays vendors for
supplies.

These factors - world-class inventory management and lack of brick-and-
mortar locations - allows Dell to earn significant profits while operating
with relatively tiny amounts of invested capital.


Disaggregating ROIC

The ROIC equation can be broken down to allow for study of the source
of a company's competitive advantage:






In general, businesses with a competitive advantage and related high
ROIC, will achieve a better than average showing in either its operating
margin or invested capital turnover, or both. The source of a strong
ROIC, in either operating margin or capital turns, will be determined by
the nature of the business. Obviously, a company with low operating
margins is not necessarily doomed to low ROIC, if the low margin is
compensated for with excellent turnover.

Price-setters, sellers of differentiated or high quality products, tend to
benefit from a high margin while price-takers that rely on high sales
volume, should show better capital turnover.

It is useful to compare these items relative to the company's peers and
monitor them over time. A gradual trend of improvement or decline in the
advantage source (operating margin/capital turnover) can be taken as
early signs of a competitive advantage growing stronger or weaker as
well as changes in the degree of competitiveness in the industry.

Summary

ROIC analysis is critical for assessing a business's ability to create value
for investors from its operating activities. When the capital invested in a
business is capable of continually generating returns greater than its
opportunity cost economic value is created.

ROIC is a better benchmark of performance than other more commonly
used metrics (e.g., ROA, ROE). The reason is that ROIC is objective in
that it is considers only capital invested in, and income earned from the
core business; secondly, it is not skewed by how the company is financed
while ROE is necessarily affected by capital structure.

Leaving price aside, when considering acquiring partial ownership of a
business, the candidate is the one that can employ the most additional
capital at the highest rate of return.

Very high and sustained operating earnings relative to capital employed
is a tell-tale sign of a strong franchise. ROIC analysis helps answer the
critical question- Is this a good business with a durable competitive
advantage?

A competitive advantage can be manifested in excellent ROIC in a
number of ways depending on the nature of the business and the "width
of its moat." Companies that command pricing power should show above
average operating margins and may also benefit from a capital efficiency
advantage. A price-taker may build a competitive advantage insofar as it
achieves cost competitiveness and capital efficiency.

As important as the level of ROIC is the ability to sustain the ROIC over
time. This is not an easy task for most businesses. Factors determining
the competitive advantage period are the firm's own competencies and
the degree of industry stability and predictability.