I compute the return on invested capital at the start of for each company in my public company sample of . Aswath Damodaran said. January 28, at am by Aswath Damodaran . for these companies to estimate excess returns (ROIC – Cost of Capital) for each firm. Return on Capital or Return on Invested Capital (ROIC) is something I . Aswath Damodaran is an NYU professor and the guru of valuation.
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In fact, the largest companies earn positive excess returns, and while I am loath to make too much of one year’s results, and recognize that there is some circularity in this table since the companies with the highest excess returns should see their values go up the mostthere is reason to believe that in more and more sectors, we are seeing winner-take-all games played out, where a few companies win, and find it easier to keep winning as they get larger.
If you are wary because the returns computed used the most recent 12 months of data, you are right be. Some of the sectors that fall into the bad business column did not surprise me, since they have been long standing members of this club.
However, if you are holding a stock for 30 years, a discount or premium to value becomes insignificant as it gets spread out over many years. Notwithstanding these concerns, analysts often compute a return on invested capital ROIC as a measure of investment return earned by a company:. This is the where the all important denominator comes in – Invested Capital.
I compute the return on invested capital at the start of for each company in my public company sample of 42, firms, using the following judgments in my estimation:. First, corporate measures of profits are not only historical as opposed to future expectations but are also skewed by accounting discretion and practice and year-to-year volatility.
For investors, looking at this listing of good and bad businesses inI would offer a warning about extrapolating to investing choices. Base Hit Investing has a wonderful post explaining this very concept in more detail, which I’ll also re-list below.
The median operating margin across all companies is 4. In the table below, I look at excess returns, broken down by region:.
Numbers don’t lie, or do they? If there is a better reason for pushing for stronger corporate governance and more activist investors, I cannot think of it. Save it to your desktop, read it on your tablet, or email to your colleagues.
Not only do the numbers here cast as a lie the notion that growth is always good, but they also let us see how disruption is changing businesses around the world. The automobile and shipbuilding businesses have been bad businesses,almost every year that Daamodaran have looked at it for the last decade.
Aswath Damodaran – January 2018 Data Update 7: Growth and Value
For those interested in digging a bit deeper into the nether reaches of ROIC, I thought that some of the best writing on the topic was worth sharing here. Some of the sectors damoadran this list will attribute their place on the list to macro concerns, with oil companies pointing to low oil prices. Small companies constantly earn much more negative excess returns than large companies.
It is also the metric that lends itself well to converting stories to numbers, another obsession of mine. I vamodaran it was a valuable instructional resource on ROIC. There is, however, a corporate governance lesson worth heeding. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.
Margins and ROC
Base Hit Investing is one of rokc my favorite investment blogs and John – the author- has penned a series of very insightful posts on ROIC. Finally, if you are doing this for an individual company, you can use much more finesse in your computation and dmaodaran this spreadsheet to make your own adjustments to the number. It behooves us, as investors, to be wary of growth in companies. The sobering note, though, is that as India opens these sheltered businesses up for competition, these excess returns will come under pressure and perhaps dissipate.
Putting both calculations side by side helps exemplify the definition and various drivers a little better. If the measure of investment success is that you are earning more on your capital invested than you could have made elsewhere, in an investment of equivalent risk, you can see why the cost of capital becomes the other half of the excess return equation.
If you look at almost every valuation that I have done on this blog or in my foic, a key input that drives my forecast of earnings in future years is a target margin either operating or net.
A few things I would say here:.
ROIC = NOPAT / Invested Capital
I find profit margins to be extraordinarily useful, when valuing companies, both for comparison purposes and as the basis for my forecasts for the future. Unlike profit margins, where profits are scaled to revenues, accounting returns scale profits to invested capital.
After talking at length about individual names, I was damoraran to hear more about how they think about ROIC – Sean kindly responded rooic some of those roid about ROIC that still keep me up at night in a very insightful post. Dividends and Buybacks in Data Update Alphabet and Costco are massive businesses with immense scale. The Amazon phenomenon, which has so thoroughly upended the retail business, seems to be coming to other businesses as well. The Math of Compounding. As you digest the bad news in the cross section, if you are a manager or investor, you are probably already looking for reasons why your company or business is the exception.
If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much ric than a six percent return-even if you originally buy it at a huge discount.
Are companies in some parts of the world likely to earn better returns on investments than others? A couple months back – I had the opportunity to meet with Sean and Arif from Ensemble Capital – two very smart guys that manage and invest money with a philosophy that’s not very different than my own – buying businesses with durable competitive advantages at a reasonable price, a concentrated portfolio of high conviction positions and a long term holding period. After all, it’s important how much money is spent to generate this operating income.
At the start ofas I have in prior years, I computed gross, EBITDA, operating pre and post-tax and net profit margins for every publicly traded company in my sample.
I’ve only scratched the surface when it comes to ROIC. Measurement and Implications Credit Suisse This is a research paper that I randomly came across online.
We would want to analyze the ROIC for both companies over multiple years to understand how sustainable it is and how susceptible it is to a cyclical downturn. While the entire sector data is available for both US and Global companies, the list below highlights the non-financial service sectors that earn less than the cost of capital:. Link to live map. It is true that my accounting returns are based upon one year’s earnings, and that even good companies have bad years, and using a normalized return on capital where I use the average return on capital earned over 10 years does brighten the picture a bit: