Investing in equity securities involves risk, which Benjamin Graham defined as a “permanent loss of capital”. Therefore, when searching for equity investment opportunities, it is important to concentrate on those businesses that demonstrate the ability to provide a satisfactory reward in exchange for assuming equity risk.
Return on Invested Capital (“ROIC”) provides the measurement of reward sought by equity investors. ROIC is a gauge of how efficiently a firm allocates the money invested in its operations towards profitable investments. It is calculated as a company’s earnings before interest, taxes, and depreciation divided by total capital (or common and preferred stock plus long-term debt). ROIC provides a concrete way to compare companies based on the feasibility of their products and the competency of their management.
Companies with the ability to generate high returns on invested capital are not easy to find. A recent screen of the 2,993 companies in the Russell 3000 Index for those with a ROIC of greater than 15 percent resulted in only 401 matches (less than 14 percent of the companies). This scarcity is why a high ROIC is one of the foundations in BNC Wealth Management’s value investing process.