When ROIC is a Flawed Metric - Part II
We're not interested in past returns: we're buying the future cash streams!
Introduction
This is part II on a previous article. We’ve already talked about ROIC, ROIIC and IRR in a separate bi-weekly webinar. Telling the story behind the numbers and analyzing perpetual compounding machines: that’s what this Substack is all about.
What we’ve seen over the past years is that many capital-light (low working capital and low maintenance CAPEX) and high-margin companies managed to dramatically improve their reported ROIC. That’s obviously a testament to their effective capital management and competitive advantages, but using that ROIC as a baseline for modeling returns on future growth investments is tricky.
As such, the main nuance lies in the fact that ROIC is an accounting metric at the back end: current profits are being stacked against the book value of invested capital (i.e. after taking depreciation into account). It does not give much insight into the cadence of future cash streams (IRR) and it doesn’t reveal the up-to-date investment cost of expanding capacity.
For some companies (primarily tech), ROIC isn’t that useful due to the lack of (tangible) invested capital. Add to that: different accounting techniques, i.e. capitalized R&D (IFRS) vs. expensed R&D (IFRS and US GAAP).
In this post, we’re going to elaborate a little more on the moving parts of ROIC and how to interpret alternative metrics. There’s no one-size-does-fit-all approach to dissecting future ROICs, and so it’s far better to be roughly right than precisely wrong.
Return on Invested Capital is one of the most important metrics to assess a company’s capital efficiency and effectiveness of reinvestments.
Notwithstanding the obvious conclusions one can draw from ROIC (the higher the better, is it above-average, does the company have reinvestment opportunities), this ratio is being generalized too often in the investment community.
Ultimately, we want companies that generate strong cash flows, reinvest for future growth and get fast paybacks on their investments. Capital preservation, healthy balance sheets, industry-leading returns, low to negative working capital, high ROIC, high IRRs on growth investments… it’s all based on common sense.
Hypothetical Example
The example used in the webinar:
A company invests in a new plant (including equipment which drives maintenance/replacement CAPEX) and has to make the following one-time investments: 50k USD in year 1 (the initial and largest cash outlay) and 10.6k USD in year 5 (extending capacity) or a total of 60.6k USD (note: the sheet shared in the webinar used 60.4k USD for calculating ROIIC, all other numbers are identical to the ones described below).
For simplicity, we do not pay attention to working capital
The company starts depreciating its property, plant & equipment (PP&E). Most of the depreciation relates to the one-time growth investment (constructing the plant).
To determine recurring investment needs going forward (to sustain current business operation) and to model a steady-state (i.e. underlying) NOPAT, we should only take recurring depreciation and thus CAPEX into account.
The item “Recurring CAPEX” reflects next year’s maintenance CAPEX that are embedded in the current year’s ROIC calculation (eg. to already account for inflation).
As mentioned previously, we shouldn’t punish companies that are investing for future growth by extrapolating all depreciation (including depreciation related to one-time growth investments) into perpetuity.