Capital Allocation - the true measure of management
Capital allocation is the most important job of management. A company that is using its capital efficiently will generate growing free cash flow and higher returns for investors in the future. This will reflect in its share price over time.
The best measure of capital allocation, for non-financial sector companies, is Return on Invested Capital. (A more appropriate measure for the financial sector is Return on Equity).
Return on Invested Capital (ROIC) in simple terms
An ROIC of 25% means that for every dollar invested in a company’s operations, the company generates $0.25 in after tax profits. So, if a company invests $1,000 in its operations, it will generate $250 in after tax profits.
“A sustainable and growing ROIC has a positive impact on a company’s cash flows and market value. At Celestial, we prefer a ROIC of at least 15%, and preferably above 25%, dependent on the industry in which the company operates.”
What does a high ROIC tell you about the company?
There is efficient use of capital. The higher the number, the greater the return management is generating from available capital.
There normally is a moat. In order to generate a high ROIC, the gross margins and operating margins need to be high. Both an indicator of pricing power and a moat.
Growth potential. In order to grow, there must be opportunities to invest, and most importantly, there must be capital to invest, this generated and thoughtfully applied through a high ROIC.
Management knows what it is doing. With surplus cash generated, management can invest it in organic growth, pay dividends, buy back shares, repay debt or make acquisitions. A high and increasing ROIC indicates management has made sound decisions in the past and this should continue.
ROIC = Net operating profit after tax (NOPAT) / Total invested capital.
NOPAT = EBIT * (1 - Effective Tax Rate), where Effective Tax Rate = Income Tax Expense / EBT, Inc. Unusual Items
Total invested Capital = Total Assets - Accounts Payable - Accrued Expense - Excess Cash
Source: Finchat.io
The evolution of ROIC over time matters:
The following the is the 10 year ROIC evolution of the Super 6 (previously known as the magnificent 7 before Tesla departed), in graph and table. The red line is Nvidia, the most cyclical of the six in the semi conductor industry, reflecting increased CAPEX in 2022 (increased invested capital, lower ROIC), followed by exceptional profitability (higher NOPAT, higher ROIC) due to the data centre, AI driven demand for its products.
Apple, Microsoft, Meta and Alphabet all have outstanding, recurring, fairly consistent ROIC’s, reflecting the maturity of their businesses. They all apply significant amounts of their surplus cash to organic growth, stock buy-backs and dividends. The laggard in this table is Amazon, whilst a great run company, requires significant CAPEX for AWS and a succesful strategy to build market share in its online retail at the cost of profitability.
ROIC percentages should be compared by industry, it makes no sense to compare the ROIC for a manufacturer to software company, the business model and especially capital intensity is different. We like to invest in companies that have ROIC above 15%, and preferably higher than 25%. There is re-investment and growth potential. In all instances, the ROIC must be higher than the WACC (weighted average cost of capital). The following table sets out a selection of companies with the defining feature being their increasing ROIC.
10 year ROIC evolution for other quality companies
ROIC is a simple measure that tells an immediate story about a company, how well has management been allocating capital in the past. This must be further extrapolated by how likely this will continue into the future. A company’s culture, its DNA and the disclosed incentives to management, must be considered to make an assessment.
Disclaimer: The information provided on this page is for informational purposes only and should not be interpreted as investment advice or as a recommendation to buy or sell any stocks. It merely reflects our views on the companies we have analysed and in certain instances in which we have invested or whose shares we have divested. Please note that the past performance is not indicative of future outcomes and should not be relied upon as such.