Return on Invested Capital as an Investment Decision Tool

We typically share insights regarding specific companies or industries. Our systematic approach of rating calculating allows us to quickly, and most importantly objectively, assess the state of affairs of almost any public business and give our assessment. We do not insist that our approach excludes alternative points of view. On the contrary, we are thrilled when our clients implement our assessment into their trading strategy and increase their returns.
But today we plan to focus not on the analysis of a particular company, but on the investment strategy primarily based on ROIC (return on invested capital).

What is ROIC?

The return on invested capital ratio shows how much net operating profit after tax a company earns per unit of funds involved in its core business. The value of 20% is the benchmark for calculating the Eyestock Rating for any company.

Key takeaways:
1. Using operating income after tax allows to neutralize the impact of the tax rate and more accurately reflects the company’s efficiency
2. Invested capital allows a more accurate evaluate the assets involved in the main activity, thanks to which the assessment of profitability is as objective as possible
3. Roic is a more progressive method of assessing profitability than return on equity (ROE) or return on capital employed (ROCE)

Let’s put ROIC at the heart of our portfolio stock selection strategy, and to do that we’ll need a Stock Screener and a bit of logic.

When we evaluate businesses, we expect outstanding companies to have a ROIC of 20% or more. Why? This is significantly higher than the current risk-free rate and almost twice the average annual return. This is enough to suggest that companies with an ROIC of 20% or higher know how to efficiently organize the production of goods and services and provide significant returns to shareholders. Could these be future growth companies? Mostly, yes.

Step 1. Set up ROIC >20%

Let’s put ROIC at the heart of our portfolio stock selection strategy, and to do that we’ll need a Stock Screener at the first step. Let’s set up this parameter as the foundation of our strategy, having previously specified the necessary parameters for exchanges (Nasdaq and NYSE) and capitalization (over $1 billion).

Well, having 288 companies on the shortlist doesn’t really simplify the task yet, so we’ll introduce a second condition. Let’s leave only those companies that… do not pay dividends! Yes exactly. This goes against the conventional logic of loving dividend-paying companies. But we will explain why we want to do this. If a company has an outstanding return on invested capital, then that company is super efficient, right? So why take money from it to receive just a couple of percent annually in the form of dividend yield. Let the management turn over and over again assets with a high return so that the company’s capitalization grows and more than covers the lost dividends. What do you think of our logic?

Step 2. Set up Payout Ratio <20%

To select such companies, we will use the Payout ratio — a share of net profit paid out to shareholders in the form of dividends. Let this figure not exceed 20%, that is, most of the earnings are reinvested. Only 37 shares remained — an excellent result! We have 37 companies, including such as NVIDIA and Meta Platforms, that reinvest most of the cash flows into profitable businesses. This could provide greater potential returns from capitalization increases. But we will continue the logical chain and add one more condition to the previous two filters — the average growth rate of net income for periods of 2 and 5 years must be at least 10%. Otherwise, what kind of growing business are we talking about, right?

These logical and interconnected simple three steps allowed us to select a sample of 22 companies. By the way, most of these companies have a high Eyestock rating, that is, more than 100%. What remains for us to do is to add to the Watchlist for further actions those companies whose growth rate over the last 2 years is higher than the 5-year one.

The final list included only 10 companies. It so happens that all of them have the Eyestock Rating above 100%, which confirms their potentially high performance in the future, because according to a backtest conducted on historical data for 5 years, companies with high ratings are almost twice the profitability of the broad market.

Here are some names from this list.

NVIDIA (NVDA stock) with the Eyestock Rating of 144% and ROIC of 103%.
This is an excellent stock with clear prospects, but it is overvalued relative to fair value calculated using the historical relative method by 25%. The ideal entry point for us шы no more than $710. Although, given the company’s forecasts to increase profits several times over the next 4 years, it seems that NVDA should trade at a higher price than average.

Meta Platforms (META stock) with the Eyestock Rating of 131% and ROIC of 35%.
Despite the rapid recovery of the stock after the dramatic fall in the share price in 2022, META is trading very close to fair value of $459, which opens up significant prospects for investment portfolios with moderate risk appetite.

Mastercard (MA stock) with the Eyestock Rating of 111% and ROIC of 62%.
We studied the company’s business performance in detail in comparison with Visa in our article Investments in Payment Solutions: Making Profit on Major Credit Card Companies. Today, buying MA shares, in our opinion, can give a growth potential of 40% to its maximum valuation (50 by P/E, taking into account the current net profit).

You can find out the entire list in our special collection .
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