Many investors and academics have written about the return on invested capital (ROIC) metric. It's an important metric to measure business and managerial quality.
However, a lesser amount has been written about the components of ROIC. There is more information that investors can use to understand economic value drivers embedded in the simple earnings divided by invested capital formula.
This post aims not to convince readers of the importance of ROIC but to deconstruct this metric into its two most fundamental components, margins and capital turnover (or capital turns).
The first component is a company's earnings margin. Margins tend to get the majority of attention on Wall Street, main street, and Washington. A company's margin reflects its ability to sell its product or service at a premium to its production cost. Professor Bruce Greenwald of Columbia University refers to high-margin businesses as having a consumer advantage. A company must generally possess a competitive advantage such as reputation or switching costs to earn and sustain high margins.
The next element of ROIC is capital turns. Capital turnover tells us the dollars of sales a business generates per dollar of invested capital, a measure of capital efficiency. Revenue divided by invested capital equals capital turnover. Companies with high capital turnover are said to possess a production advantage. A company with a production advantage will produce and deliver its products or services more efficiently to customers through superior access to production inputs, processes, or technologies.
To summarize, ROIC = (earnings/ revenue) x (revenue/ invested capital)
We can now visualize the drivers of ROIC. What other insights can investors extract from this disaggregated equation? ROIC can expand with margins or with improved capital efficiency, or both. Conversely, it can contract the same way.
But importantly, companies tend to have either margins or capital turns as a primary driver of returns on capital. This brings us to practical analysis for investors. For companies who derive their returns on capital from margins, investors can focus their attention on the factors that impact their margins, such as competitive advantage, industry dynamics, or cyclicality. For low-margin businesses that produce their returns on capital primarily through capital efficiency, investors can focus on their efforts on production, such as inventories, warehouse expansion, or changes in process and technology.
The charts below show public companies in the S&P Total Market Index that produced 20% returns on invested capital in 2021. Note that on the x-axis, we have economic earnings margin ("margin"), and on the y-axis, we have capital turns. The chart on top includes all companies that produced 20% ROIC in 2021; the bottom chart is visually cleaner to highlight the eclectic mix of businesses across the margin-capital turn spectrum.
If we zoom in, Visa, a company with a 52% margin in 2021, produced the same return on invested capital as Lowe's, which had a 6% margin over the same period. Visa operates a financial payment network that processed 165 billion transactions, or $10 trillion in 2021. Its network effects, few and relatively rational competitors, and operating leverage allow the company to earn high margins. Conversely, the business requires significant capital to build and maintain its network, which causes the company to have low capital turnover. Lowe's operates home improvement retail stores across the country. To fill its shelves, the company has to procure goods and materials from wholesalers to sell through its retail stores, a notoriously low-margin business. However, through efficient management of inventory, disciplined expansion, and a quality brand, the company can turn capital over quickly. This high dollar of sales per dollar of invested capital is the key to Lowe's ability to produce attractive returns on invested capital.
The takeaway here is that there are many ways to produce 20%, or x%, ROIC. The drivers of a company's returns on capital become clearer when deconstructing ROIC. Practitioners can use this to identify which drivers are likely to move ROIC higher or lower in the future. It also makes clear what type of competitive advantage a company possesses. With these considerations, investors can better focus their efforts on the business's drivers of economic value creation.
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