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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This requires a high quality business that benefits from a durable competitive advantage or moat and even then, it’s not always a given that the company can maintain its returns; 2 Valuation is still important but it becomes less and less dammodaran as the holding period increases. China, the other ddamodaran market in terms of population, does not seem to offer damoadran same positive excess returns, and that should be a cautionary note for those who tell the China story to justify sky high valuations for companies growing there.
To counter that, I also computed a ten-year average ROIC for those companies with ten years of historical data or more and that number compared to the cost of capital.
The distribution across all firms is reported below:. I answer that question by computing the excess returns, by country, in the picture below: The disappearance of this small cap premium, that I have pointed to in this post, may be a reflection of the changing business dynamics. The profit margins you focus on, to measure success and viability, will also shift as a company moves through the life cycle:.
The simplest and most direct measures of profitability remain profit roc, with profits scaled to revenues for most firms.
After all, excess returns can vary across parts of the world, different business or company toic. They may appear expensive in relation to earnings or book value, but over the long term, businesses and their stocks will reflect their return on capital and the majority of the return on a given investment will be driven by this factor.
If you look at almost every valuation that I have done on this blog or in my classes, a key input that drives my forecast of earnings in future years is a target margin either operating or net. Data UpdateExcess Returns.
ROIC – Formula, Examples, How to Calculate ROIC
Generally, you would expect companies in markets that are more protected from competition either domestic damodxran global to do better than companies in markets where competition is fierce. Small companies constantly earn much more negative excess returns than large companies. What drives PE Ratios? The sobering note, though, is that as India opens these sheltered businesses up for competition, these excess returns will dsmodaran under pressure and perhaps dissipate.
Compounders and Cheap Stocks. 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. Second, to measure the capital that a company has invested in its existing investments, you often have begin with what is shown as capital invested in a balance sheet, implicitly assuming that book value is a good proxy for capital invested.
If your focus is on answering the question of whether your company is a “good” or a “bad” company, looking at margins may not help very much. The list of metrics I look at when I analyze businesses is long: Does growth add or destroy value? In the context of reporting this statistic at the start of last year, I reported my ROIC caveats in a picture:.
It is also the metric that lends itself well to converting stories to numbers, another obsession of mine. I have spent the last few posts trying to estimate what firms need to generate as returns on investments, culminating in the cost of capital estimates in the last post. The nuances of calculating ROIC can be hotly debated by finance nerds like myself but my preferred approach is what is often referred to as damodaraan Asset Approach.
Of course, this comparison can be done entirely on an equity basis, using the cost of equity as the required rate and the return on equity as a measure of return: One of the posts emanated from a conversation I had with the fine gentlemen at Ensemble Capital. Specifically, damofaran I have in prior years, I will examine whether the returns generated by firms are higher than, roughly equal to or lower than their costs of capital, and in the process, answer one on the fundamental questions in investing.
Valuation is the other side of the coin. The correlation between business quality and investment returns is tenuous, at best, and here is why.
ROIC = NOPAT / Invested Capital
With all the caveats about accounting returns in place, this comparison is one of the most important ones in valuation and finance, for a simple reason. Note that the traditional definition of Net Working Capital usually excludes cash from the Current Assets but I include it in this damodaan because we then subtract out the excess cash.
Are smaller companies likely to earn larger or smaller excess returns than large companies?
Yes, ROIC isn’t perfect and there are some shortcomings including consistency of calculation -you can find about a hundred different ways to calculate it, but there is no perfect metric so it’s the best we’ve got. It’s a combination of both technical posts on the calculation of ROIC and philosophical posts on ways to think about it.
There is, however, a corporate governance lesson worth heeding. There is a semblance of good news in this table. I could tell you stories that can answer this question differently, but the answer lies in the numbers. There are two additional points I would add here: Finally, if you are doing this for an individual company, you can use much more finesse in your computation and use this spreadsheet to make your own adjustments to the number.
A Ferrari is a hell of a car but it’s not a great buy if you pay a billion dollars for it. After talking at length about individual names, I was interested to hear more about how they think about ROIC – Sean kindly responded to some of those questions about ROIC that still keep me up at night in a very insightful post.
In fact, the largest companies earn positive excess returns, and while I am da,odaran 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 doic they get larger.
Nonetheless, these assumptions don’t impact the key insights of the comparison very much so I thought it ok for this example. As to which of these various measures of profitability you use, the answer depends on the following:.