How effectively does a business allocate its capital? When you get right down to it, this is one of the most fundamental questions affecting any business. To answer this question, we need to determine the cash on cash yield for money invested in a business, or rather, its Return on Invested Capital (ROIC), which is an essential metric in determining how successful a company's management is in operating the business.

The only problem is that it's not an easy figure to come across! Most publicly traded companies will highlight their Price/Earnings (P/E) ratio, their Earnings per Share (EPS) or other financial yardsticks in their financial reports and press releases, but it's left as an exercise to the investor to mine through their financial data to extract the company's ROIC figure. While a number of stock screening tools, such as BusinessWeek's S&P Stock Screener will let you sort and rank stocks according to their most recent ROIC data, getting historical ROIC data is problematic, especially if you're interested in tracking a company's track record over time.

That's why Political Calculations^(TM) has taken on the task! Here, for the first time that I can see on the web, a tool is now freely available for the common investor to do the math it takes to uncover a company's ROIC. Sure, you could go play with only other tool I found on the Internet for doing this math over at the Millionaire Manager, but do you really want to surrender your personal information just to run some numbers? For that matter, you could take advantage of some really good resources at the Motley Fool if you want to do the math yourself, as I did in creating the tool below. But the point is to make it easier, and you're already here....

Getting the Numbers

Getting the numbers to calculate a company's ROIC can be difficult, since you will need to dig into their official Securities and Exchange Commission (SEC) filings to get some, if not all, the numbers you need. In the entry fields below, I've indicated where you can expect to find the quantities listed, with the following code:

• CSE = Consolidated Statement of Earnings (SEC Filings)
• IS = Income Statement (SEC Filings or Yahoo! Finance)
• BS = Balance Sheet (SEC Filings or Yahoo! Finance)

The default numbers below are taken from Starbucks (SBUX) 2004 Annual Report (Starbucks 2005 Annual Report should be out within the next several weeks.) Why Starbucks? Well, aside from recently linking to Hugh Chou's Stop Buying Expensive Coffee and Save Calculator earlier, which put Starbucks in my head, one of the Motley Fool's examples for calculating ROIC revolved around Starbucks 2001 data, which gives us a point of comparison for the 2004 data below.

Whenever possible, I've taken the values from Yahoo! Finance's data for Starbucks' 2004 Annual Income Statement and 2004 Annual Balance Sheet, since it's easier to find the relevant data there, but the amount for Depreciation and Amortization was taken from Starbucks' 10-K SEC filing's Consolidated Statement of Earnings on Starbucks' web site (also available in Yahoo! Finance's record of SEC Filings for the company via Edgar Online) since the annual (10-K) and quarterly (10-Q) reports will provide this figure directly. I've also tried to put the items in the order that you'll find them in the various financial statements to make data entry easier.

Comparing Historical Data

Comparing the results for Starbucks in 2004 against its 2001 data, we see that the company's management has improved its ROIC from 23.5% to 33.0%. In achieving that higher return, the company's stock increased from $7.47 per share on 30 September 2001 to $22.73 per share on 30 September 2004, with both figures adjusted for dividends and stock splits, reflecting that the company has been a very good investment through that time interval.

Looking at Whole Markets

One of the other uses for ROIC is to look at entire markets to determine if their overvalued or undervalued. For example, in the period between 1995 and 1998, a lot of people would come to the conclusion that the growth of the S&P 500's P/E ratio in that time indicated that the market was becoming highly overvalued. In reality, they were missing the link between P/E ratios and ROIC. From the Motley Fool:

The P/E ratio is not only a function of growth, but also ROIC. The market is perhaps the best example of such a relation. From 1995 to 1998, the S&P 500's P/E ratio increased from 15 to 25. Many analysts and market gurus were screaming loud and clear that the market was overvalued because it was trading at a premium multiple to its historical level. However, the reality is that while the P/E ratio expanded, there was also a significant rise in the market's ROIC as it rose from 15.5% to 25.5% (Source: CSFB, The Fat Tail That Wags the Dog). A high P/E ratio does not mean that a stock is overvalued, but simply that it is more valuable.

Conversely, Ben McClure at Investopedia notes:

From 1999 to 2003, the S&P 500 average P/E ratio fell roughly from 25 to 15, so the S&P 500 was trading at a discount to its historical multiple - does that mean the S&P 500 was oversold? Some market watchers thought so, but ROIC-based analysis suggested otherwise. Although the P/E ratio diminished, there was also a proportional reduction in the market's ROIC. This makes a lot of sense: since 1999 companies had had a much harder time allocating capital to worthwhile projects.

Of course, these are just snapshots in time. In between 1995 and 2003 we had the stock market bubble where the S&P 500 P/E ratio leapt well above the 25 level mentioned above, which wasn't backed up by matching gains in corporate ROIC levels. So, looking at market-wide ROIC data gives us a pretty good tool to know if the market is accurately valued.

Other Investing Tools at Political Calculations

• Investing: Future Value
• Investing: Rate of Return
• Investing: How Long?
• Annuity Payments
• Your Investment Portfolio
• Lemony Snicket vs. King Midas
• Your Thrift Savings Plan Portfolio
• Best and Worst Case Stock Market Investing
• Mapping Stock Market Extremes
• Investing in Real Estate for Cash Flow
• Changing Value in the Stock Market

Labels: investing, tool

- posted by Ironman at 10:00 AM | Permalink | Home |