David Trainer explains why Return on Invested Capital (ROIC), calculated as net operating profit divided by invested capital, beats other metrics for measuring true company profitability. Most companies get it wrong because accounting adjustments are complex. Netflix and Amazon look more profitable than they are; Western Digital and Viacom's numbers are stronger.
Chapters
The most important metric for measuring the profitability of a company is return on invested capital, ROIC. Not ROE, not ROI, not RONA, not ROA. None of those come close. Return on invested capital is the metric. Now, the formula is easy: net operating profit divided by invested capital. The concept is easy. How much cash does a company generate relative to how much cash has been put into the business? And by the way, that's a universal measurement. I don't care if you're a bank, a tech company, an insurance company, a manufacturer, every single company has a certain amount of cash flow that it generates relative to how much capital has gone into the business. Some companies will call it different things, nevertheless it's an immutable concept of measuring profitability, it's the best. Now the concept is simple. But implementation is difficult. In another tutorial, I talk about the importance of data quality, and that's incredibly true. Most people in the business of doing models know the saying, garbage in, garbage out. And we make it our goal in life to have the highest quality return on invested capital metrics in the world. And it makes a big difference. Because when we look at certain stocks, we see outstanding performance that other people don't see because of all the adjustments we make. And by the way, you want to know what the adjustments are? I'll tell you. They're in a blog post. The blog post is titled 30+ Adjustments for the Truth About Earnings Quality and Valuation. And I'll go into explicit detail about how we make each one of those adjustments, why it matters, and I'll give you samples of companies where those adjustments were the biggest. Why? Because I want you to know how much work we do. I want you to know how much work it is to do that in general, because then you'll realize why our research is such an incredible deal. We're going through and doing work with a level of expertise that FASB, that other regulators rely upon to construct accounting rules. Some of the top hedge funds in the world rely on our work to ensure they have the truth about the profitability of companies. So when I tell you that our return on invested capital metric is the best in the world, it is. We've identified companies like Western Digital and Viacom have outstanding profitability. On the other hand, companies like Netflix and Amazon are effectively It's overstating profitability when you look at returns on capital. They're just not as profitable as they seem on the surface. The return on invested capital is the best metric, but it's important that you also have the best data when measuring return on invested capital. Anyone can do return on invested capital, anyone can do EVA, economic earnings, but at the end of the day, ROIC is the key metric and the quality of the data is what makes the difference. And it's our goal in life at New Constructs to have the highest quality of data in the world. We've built technology, expertise, and processes about ensuring that's the case, and some of the top minds in the business, both on the regulator side and investor side, rely on our data for that reason.
