I came across the seed for this idea in what is perhaps the best article on finance I’ve seen in the past four years. Elizabeth Collins at Morningstar.com wrote an insightful piece about her favorite financial ratio — return on invested capital, or ROIC.

ROIC measures how much cash a company receives for each invested dollar. This helps discern how well and efficiently a company profits from its invested assets. She points out that more conventional metrics, like return on assets (ROA) or return on equity (ROE), rely too much on net income, a figure that can easily make an unprofitable company look like a cash cow with a little creative accounting.

I agree. That’s just another reason why free cash flows are so important. I want to know how much tangible cash is coming through the door.

Anyhow, here’s how you calculate a company’s ROIC:

1. Aftertax income = (operating income) x (1 – tax rate)
2. Invested capital = total assets – (current liabilities – short-term debt)
3. ROIC = aftertax income / invested capital

As Collins notes, “a company creates value only if its ROIC is higher than its weighted average cost of capital, or WACC. The WACC measures the required return on the company’s debt and equity, and takes into account the risk of the company’s operations and its use of debt. WACCs typically range between 9% and 12% for large-cap companies.”

Companies producing ROICs well above their weighted average cost of capital tend to be secure, cash-producing machines. I’m referring to companies like Johnson & Johnson (JNJ: NYSE) and PetroChina (PTR: NYSE). In turn, the market typically places a premium on their share price.

But there are companies out there that earn just less than their cost of capital. They are companies on the brink. Companies that with a minor adjustment (sales growth, patent approval, etc.) are poised to break through.

And when they do, the share price typically responds quite favorably.

Take the Korean blue chip Posco Steel. In 2001, Posco produced a 5% return on invested capital. That’s not so hot for a company with a 10% WACC:

Figures In Millions

But Posco had potential. They were developing technologies that would revolutionize the steel industry.

By 2003, they finally broke through. The ROIC reached 12%. And look what happened to the share price:

Double-digit gains don’t happen by chance. So if you’re serious about increasing your odds, search for small-caps with ROICs just below the company’s WACC.

Until Next Time,
Christopher Hancock
March 16, 2007

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Small-Cap ROICs was originally featured in the Penny Sleuth.