E The Importance Of ROIC

Return on invested capital, or ROIC, is a profitability ratio telling us how efficient a company is turning capital into profit. It measures the return that an investment generates for those who have provided capital (i.e., bondholders and stockholders).

The general equation is: ROIC = NOPAT / (Debt + Equity).

By linking income statement and balance sheet together, ROIC is the best measure of management performance and the primary driver of equity returns. Empirical research shows that stocks of high ROIC companies tend to outperform significantly those of less profitable firms, regardless of the market climate. I give the ROIC factor the highest weighting for my factor-based stock fundamental ranking system.

ROIC vs. P/E (Earning Growth)

Per the chart below and many other studies, the correlation between EPS growth and valuation is almost non-existent. That is, high-growth companies may have low P/E while low-growth companies may have high P/E. In fact, the r-squared value of 0.0006 in the chart shows that previous 5-year EPS growth explains less than one-tenth of one percent of the difference in prices (and hence, returns) between stocks in the S&P 500.

EPS Growth Has Almost No Impact On Valuation

Source: New Constructs, LLC.

In the meantime, ROIC explains nearly two-thirds of the difference in shareholder returns between various companies.

ROIC Is The Primary Driver Of Stock Price

Sources: New Constructs, LLC

You may be wondering why previous earning power is not a good predictor of future stock returns. One major factor could relate to the sustainability of performance metrics (i.e., less sustainable high growth rate vs. more sustainable high ROIC) since current stock price essentially reflects the present value of future business performance.

According to a study conducted by McKinsey & Company on publicly-traded American businesses, no matter how high (or low) a company’s previous/current growth rate, over time growth has historically converged to about 5% (see the chart below).