Return On Invested Capital

| April 30, 2007 | 0 Comments

Are you an average investor?  I hope not. Like lemmings over the cliff, average investors seem to grab a tight hold onto anything that has been successful lately.  I cite several phenomenon as proof, the tulip bulb bubble in Holland in the 15th century, the 1929 stock market crash, the internet bubble of 2001, and finally the current real estate bubble – which is just now beginning to deflate.

Recently, I have heard a number of investors talking about the latest craze, investing based on ROI, (Return On Investment).  At various conferences and cocktail parties, in many conversations, I have overheard a simple description that this style of investing is the new “miracle”.  The only way to win, and . . . . gasp . . . . the style that Warren Buffett uses to make all of his money!  Please don’t follow the lemmings – they are wrong!

First the problem, ROI is a way to measure your return – you put in $100 and a year later you get back $10 and all of your principal, your return is 10%.  Fairly simple.  The problem is that this is not an investment style.  What these investors are really speaking about is ROIC – Return On Invested Capital.  ROI and ROIC are easy to confuse, but measure very different things.

The ROIC is a simple formula that measures how much money an investor (you) take out of an investment compared with how much capital is needed to provide the return.  It is a great measure of a company’s management team, and the company for that matter.  It shows how good the company is at taking an additional dollar and generating an incremental return for investors on that dollar.

Why are ROI and ROIC so easily confused?  Keep in mind ROIC is your return on invested capital (not your investment).  Just because you buy a stock for $50 does not mean that your $50 is being used to generate a return.  You need to look at a company’s balance sheet to see how much capital is really being deployed.  ROIC in mathematical terms is: cash flow available to investors divided by total capital (including debt and shareholders equity).

Lots of good companies have high ROICs and it shows, as these companies are usually performing very well.   Also, it IS rumored that this is one of the metrics that Warren Buffett uses to pick his investments and we have seen evidence to support that.

As an example, Anheuser Busch (BUD) in 2006 posted a cash flow number of about 2.7 billion, they had at the time 3.9 billion in shareholders equity and another 7.6 billion in long term debt.  After all is said and done, the company took a total invested capital of $11.5 billion (shareholders equity plus total long term debt) and generated $2.7 billion of potential return to investors.  A ROIC of just over 23%, which is fantastic by any measure.

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Category: Stocks

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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