Using a key business metric can help determine if management is doing well with your money.
Making sense of the stock market takes all the help an investor can get.
One trading metric Real Money Columnist Bob Ciura uses to identify stocks with robust returns is return on invested capital, or ROIC.
“High-profile investors, including Warren Buffett, prefer return on invested capital when performing valuation,” Ciura wrote recently on Real Money. “This is among the many tools that investors have access to when figuring out valuation and measuring efficiency of stocks.”
What is ROIC and how is it useful for investors? Ciura offers some guidance on the topic.
Financial Ratio
“Return on invested capital is a financial ratio that measures a company’s ability to efficiently deploy capital,” he explained. “It measures the return the company achieves on its investments, which is an efficiency metric that investors can use to determine if the company’s management team is effectively doing its job.”
The ROIC formula is straightforward – find the company’s after-tax net operating profit, and divide it by the sum of its debt and equity capital. “The debt and equity capital combined form the capital base from which the company can draw to make investments, so the company’s ability to efficiently allocate that capital is measured by its ROIC,” Ciura noted.
The second part of the picture is to evaluate the company’s ROIC against its weighted average cost of capital, or WACC.
“The WACC is a measure of what the capital base costs the company,” Ciura noted. “It can be calculated in a variety of ways, but the easiest way is to simply take the cost of the company’s debt, and average it on a weighted basis with the company’s cost of equity, which can be measured through the capital asset pricing model, or CAPM.”
For Instance
Here’s an example. Let’s say a company has $2 billion of outstanding debt at a weighted average interest rate of 4%, and $4 billion of equity capital at a CAPM of 8%. Given those figures, the company’s WACC would be 6%, given most of the company’s capital base is higher-cost equity.
“At that point, take the company’s after-tax net profit and divide it by the $6 billion capital base to get ROIC, and then compare the result to the 6% WACC to determine efficiency of capital allocation,” Ciura advised. “If a company’s ROIC is lower than its WACC, it means the company is using capital to generate returns that are lower than that of its cost. That is economic value destruction, so we want to look for companies with positive comparisons of ROIC to WACC.”
Why does ROIC matter so much for investors?
Primarily, ROIC measures a management team’s ability to effectively create economic value with the capital with which they’re entrusted.
“The companies that do this well tend to create earnings growth over time, and therefore, higher share prices,” Ciura said. “The ones that don’t generate economic value tend to have lower earnings growth, lower valuations, and tend to produce lower shareholder returns.”
Companies that struggle with ROIC either allocate far too much capital, to the point where they cannot find enough places to profitably invest it, or they simply choose poor investments.
“As shareholders, we should demand the best from the management teams we entrust our capital to, so ROIC can be quite useful in determining the efficiency of these management teams,” Ciura added.
With a lesson ROIC and valuation in hand, here are the Stocks of the Week, as vetted by the columnists at Real Money and TheStreet.
VeriSign VRSN $214.08. 5-day performance. (-)3.02%
HP Inc. HPQ. $38.88. 5-day performance 3.57%.
Ciura applied the ROIC calculation to two companies this week – VeriSign (VRSN) – Get VeriSign, Inc. Report a company that provides domain name registry services and internet infrastructure globally, and HP Inc. (HPQ) – Get HP Inc. Report, a major tech products provider.
First up is VeriSign, which enables navigation for various recognized domain names around the world. It enables the security, stability, and resiliency of internet services, and offers registration of .com and .net domains. The company was founded in 1995, produces about $1.45 billion in annual revenue, and trades with a market cap of $24 billion.
Its ROIC rate, by the way, is off the charts.
“VeriSign has produced a recent ROIC of 192%, a staggering figure that implies the company is nearly tripling the capital base it invests,” Ciura said. “VeriSign has a relatively low capital base given its equity capital is negative, and it has a fairly small amount of debt capital. Even so, VeriSign has proven the ability over time to efficiently generate positive earnings from this low capital base.”
Ciura also points to HP Inc. as another good ROIC play.
The company offers a variety of hardware, including laptops, printers, tablets, and more. In addition, it has an investment arm that is involved in emerging technologies and companies where HP tries to generate supplemental growth over and above its core hardware business. HP was founded in 1939, generates about $66 billion in annual revenue, and trades with a market cap of $39 billion.
“HP’s return on invested capital is 168%, and like VeriSign, it has a negative equity base helping that calculation along,” Ciura said. “HP has a relatively small debt base, however, so its investment ability remains impressive even with the negative equity base.”
Ciura said that high-profile investors like ROIC, because it evaluates the management team’s ability to intelligently invest the capital with which they are entrusted by investors, which can portend earnings growth, and higher share prices.
“By finding companies with great ROIC values, we can allocate money to companies that are selective, when they choose where to invest, and have a proven track record of generating strong returns on those investments,” he said.
Darden Restaurants DRI $129.99. 5-day performance (-)2.72%.
Darden (DRI) – Get Darden Restaurants, Inc. Report has managed – so far – to survive a difficult period for restaurant chains.
Is that enough for investors? TheStreet’s Stephen Guilfoyle weighs in.
“I almost wanted to like Darden,” Guilfoyle said. “But there are some issues.”
Darden Restaurants recently released the firm’s fiscal third-quarter financial results.
For the three-month period ending February 27th, the firm posted GAAP EPS of $1.93 on revenue of $2.449B. “While the sales number was good enough for year over year growth of 41.6% (an acceleration over the prior quarter), last year makes for a poor comparison for restaurant businesses, and performance fell short of Wall Street’s expectations at both the top and bottom lines,” Guilfoyle noted.
Same restaurant sales increased 38.1%, while 33 new locations were added. Same restaurant sales grew 29.9% at Olive Garden, by 31.6% at LongHorn Steakhouse, by 85.8% for the Fine Dining segment, and by 55.2% for all other businesses in aggregate. At quarter’s end, Darden was operating 881 Olive Gardens, 539 LongHorn Steakhouses, 173 Cheddar’s Scratch Kitchens, 85 Yard Houses, 61 Capital Grilles, 44 Seasons 52’s, and 72 other locations.
Additionally, average weekly sales increased from $73,404 last year to $101,490.
“This beats the $100,195 weekly average from the year prior,” Guilfoyle noted. “Darden repurchased $382M worth of outstanding common stock over the three months.”
Though the year prior was certainly not the standard, the ball is moving in the right direction, Guilfoyle said. “While sales were up 41.6% to $2.449B, operating costs and expenses increased 35.5% to $2.147.9B, leading to operating income of $301M (+103.3%), and ultimately net income of $247M (+91.9%),” he added.
Darden ended the reporting period with a net cash position of $555.3M, down from $1.215B nine months earlier and from $746.3M the previous quarter.
“This drops current assets to $1.28B, a third consecutive month of declines for that entry,” Guilfoyle said. “Current liabilities hit the tape at $1.815B, up a rough $100M mostly due to an increase in net unearned revenues.”
That leaves the firm’s current ratio at an “ugly” 0.7, down from 0.85 three months ago.
“The implication would be that at some point in the near to medium term, Darden could have a difficult time meeting the firm’s obligations,” he added. “Total assets amount to $10.205.4B, which still easily outweighs liabilities less equity of $7.919.6B.”
DRI has been in a downward sloping trend since peaking last September and Guilfoyle believes management did a nice job getting through a difficult quarter to manage across several fronts.
“I like the fact that the stock is nowhere near over-valued at 17 times forward looking earnings, and I like the fact that DRI pays an annual $4.40 a year dividend (yielding 3.36%) just to hang around,” he noted. “That said, should a firm with a balance sheet suffering a period of quality erosion really be repurchasing common equity and paying out a handsome dividend? Maybe. Maybe not.”
Guilfoyle plans on giving Darden another quarter to get its act together.
“I’ll see how it develops and if the balance sheet shows some improvement,” he said. “Should the shares pressure the lower bound of that Pitchfork model, sub-$116-ish, I’ll be tempted.’
“But if I can get paid $5 or more to get short July $115 puts or $3 or more to take on $110 equity risk also expiring in July, I would have to seriously consider that,” he added.
American Woodmark AMWD $50.10. 5-day performance (-)16.67%.
Real Money’s Paul Price rates American Woodmark (AMWD) – Get American Woodmark Corporation Report among his top three largest dollar holdings. That doesn’t mean he’s happy about the stock’s performance lately.
“I was early to the game, and it has been frustrating watching it fall over the past year,” Price said.
Price has been continuously averaging down on his position as he feels “very confident” that good news is now just around the corner. He revisited the stock’s charts last week and looks to refresh that outlook.
“Fiscal 2021, which ends April 30 of this year, was a horrible year due to lumber-price spikes that were not initially compensated for with product price increases,” he said. “EPS will likely have been approximately halved.”
All that changes, starting with the next quarterly report, Price said.
“Management indicated that about $55 million in extra revenue is expected in the end of April quarter due to those price increases finally filtering through to the top line,” he said. “With less than 17 million shares outstanding that will have a major positive impact on all future reports.”
Last year’s fiscal fourth quarter began a string of four straight disappointing year-over-year comparisons. Going forward, though, those easy to beat numbers should make for outstanding EPS growth.
“That is the catalyst which should finally turn AMWD loose,” Price noted. “Whether you think Value Line’s $6.75 estimate for fiscal 2022 or Yahoo Finance’s $6.50 projection is more accurate, there’s no doubt that quarterly reports will be a lot more pleasing for the foreseeable future.”
Price also points out the only time the stock was cheaper was at its Covid-panic low. “From there, AMWD surged from $35.30 to $108.80 (+208.2%) in less than a year,” he said.
“American Woodmark checks every box for excellent upside potential,” he added. “Insider buying, positive future quarterly comps and a historically low valuation are aligned to set off a furious run back to a much higher price.”
