Most people use ROE (Return on Equity) as a measurement of performance but ROE has a big drawback.
ROE = Net Income / Book Value
As you can see, book value is the denominator which means that if book value was to be reduced, the ROE would in fact increase. How would this happen? If a company writes down any of its assets, the book value would immediately decrease which results in a higher ROE.
The same would happen if the company increased its debt since book value is calculated as assets – liabilities.
The company didn’t perform any better, yet you are given a false picture. So ROE isn’t that great to use. Not even in a screen because you have a high chance of getting value traps.
Instead, ROIC (Return on Invested Capital) is a much better alternative performance metric to find quality investments as it measures the return on all invested capital , including debt-financed capital. It is the effectiveness of the company’s employment of capital.
ROIC is a lot of math but luckily it’s simple stuff without any of the Greek symbols that make your head spin.
ROIC = NOPAT/Invested Capital
For the numerator (the top part of the fraction)
NOPAT = Net Operating Profit After Tax = Operating Income x (1 – Tax Rate)
The denominator (a variation used by F Wall Street)
Invested Capital = Total Equity + Total Liabilities – Current Liabilities – Excess Cash
Excess Cash = Total Cash – MAX(0,Current Liabilities-Current Assets)
An even better metric that you can use is CROIC which I use to great effect in my stock value spreadsheets. CROIC is a.k.a CROCI but they both stand for Cash Return On Invested Capital.
You can also check out the CROIC ROIC screen backtest to see how it performs.
CROIC shows how much free cash flow per dollar the business generates from invested capital. I find this to be the ultimate performance metric as it shows so clearly how effective management is and the strength of the business.
CROIC = FCF/Invested Capital
The higher the CROIC, the more cash the company is generating and it also indicates that the business is a profitable one. Rarely do you see a high CROIC but low or negative FCF.
Of course you can use owner earnings instead of FCF.
Until recently I’ve been looking for companies with high CROIC, usually above 10%, but with my latest screen and backtests, I’ve concluded that it isn’t the level of CROIC that is important but whether CROIC is increasing.
This makes sense because if a business has a CROIC of 15% in year 1 but then in year 2 it drops to 12% followed by a drop to 10% in year 3, the average is 12.3% but the picture is different to why I first liked the company to begin with.
Instead, if CROIC is low or even negative, assuming CROIC was to increase, it indicates that management is getting things back on track which will make for a much better investment.
This is something I’ll be going over I’ll be going over in the posts to come. I’ll detail the strategy and performance of stock screens based on ROIC and CROIC.
Update: CROIC strategy backtest has been performed.