One Company Measurement You Need To Check When Interest Rates Are High

One Company Measurement You Need To Check When Interest Rates Are High
Paul Allison, CFA

5 months ago2 mins

Arguably, a CEO’s most important job is capital allocation: how they spend a firm’s cash. Investors often just look at a firm’s profit, see, but that doesn’t tell you how much money was spent to make that profit. So to get the full picture, you need to look at the “return on capital”, which shows profit as a percentage of the money shelled out. That’s only half of the equation, though: what really matters is how that return compares to the cost of the cash spent. The bigger that gap – or spread between return and cost – the more value has been added, and usually the firm’s stock is rewarded for that.

Thing is, finding projects or investments that generate a standout return is tough. A CEO could generate a decent profit by building a new factory or opening a new shop. But as an investor, you’ll want to know the context of how that profit compares to the cost of building that factory or shop. Now, let’s say that a firm wants a “spread” – that’s the return minus the cost – of 10%. When interest rates were 1% (that’s the cost part), any spending that earned a return of 11% or more was golden. But with interest rates now north of 5%, projects must return 15% or more to make that 10% spread. And because opportunities like that are few and far between, only the very best CEOs and management teams can consistently invest in a way that delivers attractive spreads, or returns.

Inside a company, head honchos can get super granular, measuring returns on capital for each new factory or new machine. While investors can’t do that, they can look at a firm-wide equation that captures it all. That’s return on invested capital, or ROIC: a measure of a firm’s profit as a percentage of all the capital that’s been invested in the business. It captures a CEO’s individual decisions, and if they make more good decisions than bad over time, a firm’s ROIC should reflect that.

So the next time you’re sizing up a potential investment, be sure to check out ROIC. Depending on the industry, I generally look for a result of 20% or higher. And get this: the markets tab in your Finimize app shows you ROIC. (That’s handy.)

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