What is ROIC and what does ROIC breakdown tell us about a sector?

A business creates value when the Returns on Invested Capital exceed the Cost of raising that Capital.
Consistently high ROIC (>> Cost of Capital) is a recipe of enormous shareholder value.

ROIC โ€” also referred to as the measure of Quality of investment โ€” is a function of
a. how efficiently capital is deployed ( measured as revenue generated per $ invested )
b. profitability

ROIC = Operating Profit (post tax) / Invested Capital

Re-arranging the formula

ROIC = Revenue / Invested Capital * Operating Profit (post tax) / Revenue
or
ROIC (pre-tax) = Capital Efficiency * Operating Margin

โ€”โ€”โ€”โ€”โ€”โ€”โ€”โ€”โ€”โ€”โ€”โ€”โ€”โ€”โ€”โ€”โ€”โ€”โ€”โ€”-

Breaking down ROIC into Capital Efficiency and Operating Margin โ€” tells us about sector characteristics.

Let’s look at these metrics for a few sectors.

Sector:
Capital Efficiency * Operating Margin = Pre-tax ROIC

๐Ÿ›’ ๐—ฅ๐—ฒ๐˜๐—ฎ๐—ถ๐—น:
Dmart 3 * 6.7% = 20%
(revenue of โ‚น3 per โ‚น of invested capital * EBIT margin of 6.7% = pre-tax ROIC of 20%)
What does this tells us?
High capital turns (low capital intensity), low margins โ€” since this is a volume business.

Do this breakdown for a luxury retailer!!

๐Ÿฅ ๐—›๐—ผ๐˜€๐—ฝ๐—ถ๐˜๐—ฎ๐—น:
Kovai Medical 1.1 * 20.6% = ~23%
Narayana 1.3 * 18.3% = ~24%
Medanta 1.0 * 18.3% = ~18%
Capital intensive sector (low revenue per โ‚น of invested capital), good margins

๐Ÿ‘ฉโ€๐Ÿ’ป ๐—œ๐—ง ๐—ฆ๐—ฒ๐—ฟ๐˜ƒ๐—ถ๐—ฐ๐—ฒ๐˜€:
Infosys 2.6 * 20.7% = ~54%
HCL 2.2 * 18.2% = ~40%
Low capital intensity, good margins

๐Ÿ๏ธ ๐—”๐˜‚๐˜๐—ผ๐—บ๐—ผ๐—ฏ๐—ถ๐—น๐—ฒ:
Eicher Motors 6.6 * 26.2% = ~173%
Hero Motocorp 2.8 * 12.1% = ~34%
TVS Motors 1.3 * 11.9% = ~16%
Eicher being a premium player enjoys both low capital intensity and healthy margins vs mass players

๐—ง๐—ฒ๐—ฐ๐—ต๐—ป๐—ผ๐—น๐—ผ๐—ด๐˜†:
Microsoft 0.9 * 44.6% = ~40%
Netflix 1.0 * 23.8% = ~24%
High investments into intangibles/goodwill leads to high capital intensity; healthy margins


You need to double click on
a. Invested Capital โ€” fixed assets, working capital, intangibles, goodwill, others assets โ€” identify which of these is a large number thatโ€™s impacting capital efficiency.
b. Operating Profits โ€” cost of goods, SG&A, depreciation โ€” identify which of these is driving low/high profits.
It will give you a sense of the sector/business


Hope this helped!

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Gautam is the passionate equity researcher and instructor at Invest and Rise