Return on capital (ROE, ROI, ROIC, RONIC)
Creating shareholder value is vital to any listed company’s existence. Shareholder value creation is therefore one of the most important tasks of a listed company.
Let us define the creation of shareholder value in this text as follows: a company creates shareholder value if its return on capital invested exceeds its required rate of return and hence its cost of capital. Companies with a return on capital that does not meet the required return are unlikely to be successful in the long run. A high return on capital relative to the industry is often a sign of a company's potential competitive advantage and thus of its quality, and therefore worthy of the close attention of the long-term investor.
Shareholder value through return on capital
In most cases, the success of a company is the sum of many factors, such as its operational performance, its ability to create value and its management's ability to allocate capital. In our view, this could include ROIC (return on invested capital), which may have been overlooked by many investors.
A company only creates value from its business if the return on invested capital (ROIC) is higher than the weighted average cost of capital (WACC). Investors must remember that in the short term, investments rarely translate into positive cash flow. However, if this does not happen in the longer term, the company's business destroys value. In turn, business growth only creates value if the return on new invested capital (RONIC) is higher than the required rate of return.
Investment decisions or financing decisions?
While return on capital is an important metric for the long-term investor, it should be interpreted with care. Return on equity can be influenced by, e.g., the amount of leverage, which should not be directly related to investment decisions that are essential for sustainable value creation. Investment decisions should therefore be seen as separate from financing decisions.
In the example, investment A has a higher return on investment than investment B, but we see that investment A has a lower return on equity than investment B. This is due to the financing decision of investment B to use more debt than equity to finance the investment. If the investor had looked only at the return on equity, they would have been left in the dark about which investment decision was better.
Not just a piece of paper, but a vehicle of allocation
When you buy a share, you are not just buying a piece of paper on the stock exchange, but an ownership stake in a potentially value-creating company. A long-term investor should therefore think of the company as a vehicle for allocating capital, and not just as a piece of paper to be bought on the market. In essence, this means that the investor outsources the reallocation decisions of the cash flow generated by the business to the management of the company. The shareholders should therefore be aware of where and especially how the company allocates its available capital. The following metrics help us in this work.
ROE (Return on Equity)
For many people, return on equity is the most familiar capital return metric. In principle, ROE is very easy to calculate and can be calculated by, e.g., dividing P/B by P/E. Return on equity gives the investor an idea of the ratio of the company's net profit for the year to the equity invested in the business. ROE is the best measure of return on capital, especially for banks.
Equity is calculated by deducting debt from the assets on the balance sheet. In other words, balance sheet total - current liabilities - non-current liabilities. Equity can also be split, for example, as follows: equity capital + retained earnings + equity loans (e.g. hybrid loans) + revaluation reserve + other equity. In ROE, net profit is usually divided by average equity, which describes the company's ability to earn a return on the equity it had at its disposal during the financial year.
The table below shows that although company A makes a higher profit, it loses out in capital efficiency to company B, which makes a better ROE.
However, one problem with ROE is that net profit does not necessarily best reflect the free cash flow generated by the company. As stated above, ROE also does not take into account the company's indebtedness, which allows the company to enhance its return on equity by increasing its debt.
According to financial theory, the value of a share is determined by the present value of its future free cash flows, but the market often follows the net profit, i.e., earnings per share (EPS) and thus the ROE ratio in the short term. However, monitoring only net profit-based multiples as a measure of value creation can be short-sighted and misleading, as growing EPS does not necessarily mean that the business will create value for its shareholders in the long term. This is because EPS does not take into account how much capital has been needed to generate net income or free cash flows and how much has been paid for it. This is particularly important for the long-term creation of shareholder value.
ROI (Return on Investment)
Return on investment takes into account the capital structure of the company, unlike ROE. This figure is often used for leveraged companies, as it gives a more accurate picture of the return on total capital than ROE. ROI is calculated by dividing the net profit plus financing costs and taxes by the long-term and short-term interest-bearing liabilities added to equity.
ROIC (Return on Invested Capital)
Another way to calculate return on investment is to calculate it by ROIC. This calculation method uses NOPAT (Net operating profit after tax), i.e., the operating result taking into account cash flow-based operating taxes.
ROIC is, in our opinion, the best return metric for the long-term investor. If the net result is the bottom line of the income statement, it may have been tainted by accounting dirt that spoils the ROE. Net income can be affected by non-recurring items, capital structure, tax rates in different countries, changes in fair value and alternative billing methods. As the operating profit included in ROIC is higher in the income statement, we believe that it better reflects the cash flows that are of interest to the shareholder and more comprehensively reflect the value creation capacity of the business than the other figures presented earlier.
Investors should also look at ROIC because it gives an indication of the company's ability to reallocate capital. As with all these metrics, ROIC requires a company to be able to make a return in order to assess its profitability. In other words, for early-stage companies, the usefulness of ROIC is likely to be poor.
The items in the table below can be found, e.g., in the Income Statement and Balance Sheet sections at the end of the Inderes reports, in case anyone is inspired to calculate these themselves.
When looking at ROIC, the DuPont analysis can be applied to distinguish where the ROIC is formed. The DuPont analysis dissects the ROIC in terms of the operating margin and the turnover rate of operating capital.
The building blocks of the DuPont analysis can be illustrated, e.g., with the square below. According to the four-field presented by Maboussin, a high operating margin indicates a consumer advantage, and a fast capital turnover rate indicates a production advantage. Moreover, the combination of these indicates a significant consumer and production advantage.
RONIC (Return on New Invested Capital)
RONIC shows how the new investments made by the company are performing. The growth of the company only creates value if the reinvested capital is greater than the required return. If the company is unable to do this in the long term, i.e., if there are no attractive investment opportunities, it should return capital to shareholders or pay off any debts.
RONIC is calculated as the ratio of the change in operating return NOPATT+1 - NOPATT+0 to the change in invested capital ICT+1 - ICT+0. In practice, this gives the investor an answer to how much new capital the company must have invested in its business in order to achieve operational earnings growth.
In the following graphs, we illustrate how growth does not create value, but rather destroys it, if the return on new invested capital falls below the cost of the capital required for it.
In the graph below, the company's operating profit after tax, or NOPAT, increases steadily over the review period. However, we see that growth has not come without costs as ROIC falls below the cost of capital by the fourth year. This happens because the company has invested in its business at a lower return on capital than what the capital costs it. In this case, the development of NOPAT alone does not give a complete picture of a business's ability to create value. In this case, from the shareholder's point of view, the earnings growth has been destructive of shareholder value.
The graph below shows the same situation, but with a DCF-derived valuation model via EVA. We see how the present value of Economic Value Added (EVA) becomes negative after the fourth year. This means that the company does not create value with its investments but destroys it.
Summary
In simplified terms and from the perspective of future value creation, an investor should focus on the following issues rather than on earnings per share:
- How much does the company's business generate in relation to the assets it commits?
- How long will the company be able to maintain the current/high return on capital?
- How is the company able to reallocate the cash flows generated by the business?
