When given the option to be part of a business, as an investor you should look at the profitability of the venture.
Before we get to that, here are some other things you should consider too…
The Potential for a Solid Return: Investing – no matter how diligent your research is, or who the managers of the company are – involves a high degree of risk.
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You, as the investor – or business owner – should have the expectation of doing more than just getting your money back. You should be looking for a higher return on your investment than you can get elsewhere.
An Experienced Management Team You Can Trust: A solid, complete management team with leadership ability is a must.
Another must is that you must be able to trust the managers are doing what’s in the best interest for the long-term health of the company and its shareholders.
If I can’t trust that the managers are doing this, I don’t invest in the opportunity. Ever.
No matter how undervalued it is and no matter how big the upside is.
Because if I can’t trust the managers are going to do what’s in the best long-term interests of the company and its shareholders, why should I trust them to run the company I’m invested in or thinking of investing in?
A Solid Business Model: Not all business models are created the same…
Some kinds of business models almost ensure long-term profitability – if you can trust managers. While others are almost always doomed to unprofitability.
You should seek the former kinds of business models.
A Viable Exit Strategy aka A Catalyst: Before you invest in anything, you should think of your potential exit strategy.
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This is especially important for investing in private entities…
If you’re considering buying a publicly traded stock – in general, you can sell it almost whenever you want to.
And even then, it still helps to envision an exit strategy or catalyst because these will increase the value of the investment faster.
Here are some common public company exit strategies / catalysts:
- Going Private Transaction
- Spin-Off
- Asset Sale
- Liquidation Event
- Merger
- Buyout
- Special Dividend Payment
- Acquisition
- And so on…
But if you’re invested in a private business, an exit strategy / catalyst is even more important.
Private companies are not liquid – meaning you probably can’t sell your shares any time you want to.
Sometimes you may have to wait up to 10 years or more to be able to “get out” of an investment.
But if there’s an exit strategy / catalyst this could come a lot sooner and you would earn your investment back a lot quicker.
Now what does all this have to do with measuring profitability?
Everything.
Because while these are important guidelines to follow when considering a potential investment, you also need to know if is it profitable or not.
ROIC As One of My Favorite Ways to Measure Profitability
Return on invested capital (ROIC) is a profitability ratio.
It measures the return that an investment generates from its capital – assets, liabilities, cash, debt, etc.
Essentially, ROIC shows us how good a company is at turning capital – think investable assets – into more and higher profits.
Here’s how I measure ROIC…
ROIC = EBIT / (shareholders equity + debt and debt equivalents – cash & cash equivalents and other investments.)
EBIT is also known as operating profit – the profit a company earns from its operations after accounting for things like the cost of goods sold and selling general, and administrative expenses.
Shareholders equity is the net assets – assets minus liabilities and whatever is left over in the positive is called shareholders equity.
Debt and debt equivalents are short and long term debt and other things like pensions and capitalized operating leases.
Cash and cash equivalents are exactly what it sounds like.
And other investments are generally investments in subsidiaries or other third-party companies.
I measure ROIC like this because it allows me to see how well the company uses its capital – investable assets again – to create more and higher profits.
The higher this number is, the better – I look for this number to be above 10% on a consistent basis.
ROIC is most useful when you’re using it to calculate the returns generated by the business operation itself compared over time to previous year periods. Not the results from one-time events like asset sales.
Why This Matters?
A firm’s ROIC is one excellent indicator of the size and strength of its competitive advantage or moat. If a company can generate ROIC of 15-20% year after year, it has developed a great method for turning investor capital into profits.
Almost always you want the company you’re considering investing in to be profitable. Generally, the more profitable it is, the better.
ROICs above 10% on a consistent basis not only means the company is producing a large percentage of profits over the years, but with a high ROIC also comes an increase in the value of the underlying company – and your investment or potential investment – as well.
For more information on ROIC, click here…
For more information on how we can help you and your business with proper capital allocation – including implementing a real-world focus on ROIC, go here.
What are your thoughts on capital allocation and ROIC? Would love to hear them in the comments below.
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