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Using ROIC to determine whether to buy

At Investment Moats,one of my criteria used for monitoring is to use ROIC. Why? Because i feel the demoninator is much more meaningful in the sense that debt like equity demands a measurement to determine whether lendin those money gives you a worth while performance.

Here is a nice article on MSN Money’ Jim Jubak that talks about it:

If I’m looking for a long-term investment, I don’t start with any of the usual measures, such as price-to-earnings ratios, P/E-to-growth ratios, earnings growth rates, or price-to-book or price-to-sales ratios.

I start with ROIC, short for return on invested capital. I don’t think there’s a single number that tells investors more about whether they want to buy and hold a stock. It’s also a good basis for lots of other investment decisions, such as whether a company acquisition is a good deal for shareholders. (For more on that, see my column of Feb. 25.)

Return on invested capital tells investors how good a job a company is doing at investing its money in profitable opportunities and how good the company is at finding those opportunities. Crucially for long-term investors, it also indicates how good a job the company is doing at compounding investors’ money through the rate of return the company gets on reinvested profits. (ROIC isn’t the most common of financial measures, but you can find an example of it here.)

One of the reasons stocks are such a great long-term investment — if you pick the right ones — is that companies generate cash from their operations that they then reinvest in those operations. Today’s profits compound over time to produce even more profits in the future.

You should own shares of a company with a high ROIC for the same reason you should put your cash in a savings account that pays a high rate of compound interest.

Let me explain how this works and show you how powerful it is by looking at one of the best ROIC stories in Jubak’s Picks, McDonald’s (MCD, news, msgs). (See my most recent update on the Golden Arches.)

McDonald’s is almost the perfect ROIC long-term holding:

  • The company throws off a ton of cash. For example, in 2008, cash flow from operations came to $5.9 billion. It was $4.9 billion in 2007 and $4.3 billion in both 2006 and 2005.
  • The company has found opportunities to invest a huge hunk of this cash flow. In 2008, the company recorded $2.1 billion in capital spending. In 2007, that figure was $1.9 billion; in 2006, it was $1.7 billion.
  • It gets a huge return on this invested capital. The company’s most recent return on invested capital was 19.1%. That’s just a little bit better than your bank gives you on your savings account, right?
  • The company looks to have lots of opportunities for investing its capital in the years ahead. Capital spending in 2010 is projected to increase to $2.4 billion from its $2.1 billion outlay in 2009. The company has ambitious programs to expand into China, refurbish existing restaurants and add items to its menus.

OK, McDonald’s isn’t perfect for a long-term investor. From that point of view, it distributes too much cash to shareholders in the form of dividends. A 3.4% dividend is nice, but I sure can’t find anyplace to invest it and get a 19.1% return. I can easily fix that problem by reinvesting my dividends, though.

[Read the rest of the article here >>]

I run a free Singapore Dividend Stock Tracker available for everyone’s perusal. Do follow my Dividend Stock Tracker which is updated nightly  here.

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