A company’s debt can work for or against investors, depending on whether management turns that money into bigger profits before the loan paybacks just drag down shareholder returns. Return on invested capital figures help investors see whether a company’s debt is fueling gains or taking a toll on earnings.
ROIC looks at all the money invested into the company, both by shareholders and lenders, to measure how well management uses all that cash to generate profits. YCharts uses a formula of net income averaged over 12 months divided by shareholder equity and long term debt averaged over the past five quarters. (Others may use different time periods.)
ROICs are best used as comparisons within sectors rather than as definitive goals. Generally, the companies with the highest ROICs are making more profits out of every dollar invested, and not surprisingly, they often show the biggest share price gains. Consider a few of the top ROICs in the clothing makers sector in early 2012.
LULU data by YCharts
The ROIC corrects for a common problem investors hit when they try to use the more traditional return on equity metric for measuring management performance. Because ROE does not include debt (which is subtracted out to get shareholder equity in either case), companies boost their ROEs as they add debt, even if that debt only drains money for shareholders.
Consider the ROE comparisons in the textiles example. Hanesbrands’ (HBI) 41% ROE was right up there with lululemon athletica (LULU). But the stock certainly didn’t live up to lululemon’s performance during the previous 12 months.
A look a Hanesbrands’ ROIC offers clues to the discrepancy. At about 10%, its ROIC was a fourth of its own ROE. Lululemon’s ROIC was equal to its ROE because it had no debt. Hanesbrands had a considerable debt-to-equity ratio.
In fact, Hanesbrands was still digging itself out of the billions of dollars of debt Sara Lee Corp. (SLE) loaded it with in 2006 when it spun off the t-shirt and underwear unit. Hanesbrands consistently reduced the debt burden, but that meant it had little cash left for the kind of brand-building efforts that would have built sales faster. In 2011, the vast majority of free cash flow was still being spent every quarter on debt management. In the fourth quarter of 2011 alone, Hanesbrands spent about a quarter of its earnings to pay off floating-rate notes.
ROIC isn’t a perfect measure by any means. Just like ROE, the result will skew higher if the company is buying back a lot of its shares, and that’s not necessarily a sign of great management. But particularly when there’s debt involved, it’s a better place to start.