Thread by @KoyfinCharts

Michael Mauboussin and Dan Callahan recently shared a great paper, updating their work on ROIC.

"Companies that delivered high and sustained ROICs exceeded their peers in both net operating profit after taxes (NOPAT) margin and invested capital turnover".

Some highlights 🧵

1/ Making money is too modest a goal, says Mauboussin.

If that investment could have made superior returns elsewhere, the foregone profit from that alternative is an opportunity cost. As such, the opportunity should be the hurdle rate for an investment.

2/ This "dollar bill" test makes sense in theory but is not perfect because a company’s market value echoes both historic and future investments.

Due to differences in growth rates, spreads between ROIC and WACC can vary. But the market tends to reward these spreads.

3/ What is most important is ascertaining what is already priced in, and being able to anticipate revisions to those expectations.

"If you have a good estimate for ROIC and a forecast for growth, you have the ingredients to estimate free cash flows".

4/ Between 1990 and 2022, the majority of Rusell 3000 companies earned ROIC of between 5% to 10%.

The adjustments (light blue) for intangible investments tend to pull ROICs toward the average, with fewer extreme values.

5/ Over the same period, the average annual for traditional ROIC measurement is 9.5% vs 9.2% for the adjusted version.

6/ The importance of intangibles adjustment varies by industry. Some are more reliant on tangible investments, so adjusting for intangibles has a lower impact on ROIC.

Here is how ROIC differs across industries, over the period 1990 to 2022, using the traditional method.

7/ And here is the same group of industries, but with adjustment.

The adjustment once again demonstrates the degree of dispersion and displays fewer extreme values.

8/ Stocks with high ROIC will not deliver attractive returns if they fail to exceed expectations.

"The reason is that a stock price reflects the market’s expectations about a company’s future financial results. Excess returns are the result of revisions in expectations".

9/ Knowing how companies generate high ROIC can inform competitive analysis.

"A relatively high margin indicates a differentiation strategy. Relatively high capital turnover is consistent with a strategy of cost leadership".

10/ "ROIC provides a glimpse into the generic strategies that companies pursue to create value [and] companies that pursue a differentiation strategy have been more represented among companies delivering superior returns over time".

11/ Time horizon influences what is important to investors.

"Investors with a short-term horizon tend to focus on near-term financial metrics such as sales and earnings. Investors with a long-term horizon focus on competitive advantage and the size of the market opportunity".