Saturday, November 26, 2005

Importance of ROIC versus Earnings Growth

As this link from DeepWealth effectively discusses, the return on invested capital is the most simple measure of the effectiveness of the whole company. Earnings growth is highlighted by many Wall Street analysts, yet that growth generally comes at a price, heavy investment in fixed assets, investment in working capital such as accounts receivable and inventories, or the funding of the business with incremental stock issuance. Joel Greenblatt of Gotham Capital has highlighted the importance of buying solid businesses at bargain prices. What defines a business as being solid? From the standpoint of its inherent profitability there is no better measure than ROIC.

ROIC provides a view of how effectively capital is being deployed in the business regardless of capital structure, that is, the proportion of debt versus equity. Highly leveraged businesses can show very high returns on equity since very little equity is deployed. A slight change in such a business' fortunes will result in a large change in ROE. Return on invested capital "looks through" the capital structure to measure the operating profitability of the business, not just how the business was financed.


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