These are important fundamental metrics I use to determine the value of a company
ROIC, ROCE and FCF are important metrics for investors to consider when evaluating the financial performance of a company. By understanding ROIC, ROE and FCF and the factors that can affect it, investors can make better investment decisions and identify companies that are generating higher rates of efficiency and returns on their invested capital.
Return on Investment Capital (ROIC) and Return on Capital Employed (ROCE) are both measures of how well a company is using its capital to generate profits, but they are calculated in slightly different ways.
ROIC measures how efficiently a company is using all of its invested capital, including both debt and equity. It compares a company’s operating income (profit from its operations) to its total invested capital. This includes all the money that has been invested in the company, including money from shareholders (equity) and borrowed money (debt). So, ROIC takes into account all the money the company has received from all sources, whether it’s from investors or from borrowing.
ROCE, on the other hand, only measures how efficiently a company is using the money it has raised from investors. It compares a company’s operating income to its equity capital and long-term debt. So, ROCE only takes into account the money the company has received from its shareholders and any long-term borrowing it has done.
To put it simply, ROIC looks at all the money a company has to work with, including money from borrowing, while ROCE only looks at the money the company has raised from investors.
Both metrics are important because they can tell investors how efficiently a company is using its capital to generate profits. However, because ROIC includes borrowed money, it can give a more complete picture of a company’s financial performance. But ROCE can be useful for investors who want to focus specifically on how well a company is using the money it has raised from shareholders.
Let’s dig deeper into my personal 3 favorite metrics.
Return on Investment Capital, or ROIC for short, is like a scorecard for a business. ROIC shows how well a business is doing at making money with the money it has.
Let’s use the concept of a lemonade stand for simplicity.
Say you have a lemonade stand and you use R100 to buy lemons, sugar, and cups. You sell the lemonade for R10 per cup and at the end of the day, you make R200 in sales. Your profit is R100 (R200 in sales minus R100 in costs).
Now let’s say your friend also has a lemonade stand and also spends R100 on supplies. However, your friend only sells one cup of lemonade for R10, so they only make R10 in sales. Their profit is only -R90 because they spent R100 on supplies but only made R10 in sales.
The formula for ROIC is:
ROIC = Operating Income / Invested Capital
If we calculate ROIC, we take the profit divided by the amount of money invested. In this case, your ROIC is 100% (R100 profit divided by R100 invested). This means that your lemonade business generates 100 cents of return for every 1 Rand invested.
In your friend’s case, their ROIC is -90% (-R90 profit divided by R100 invested). This means that their lemonade business generates 10 cents of return for every 1 Rand invested.
A high ROIC means the business is doing well because it’s making a lot of money with the money it has. A low or negative ROIC means the business is not doing well because it’s not making enough money with the money it has.
Return on Capital Employed (ROCE) is a measure of how well a company is using its money to make profits.
Let’s use the concept of a lemonade stand for simplicity again. Imagine that you have a lemonade stand, and you invested R100 to buy lemons, sugar, and cups. You sell your lemonade for R200 and make a profit of R100. That means your ROCE is 100% (R100 profit divided by R100 invested, times 100).
ROCE is like a report card that tells you how good you are at making money with the money you have. It helps you figure out if your business is making a lot of money with the money you put in or if it’s not doing so well.
For example, if a company has R1000 of capital (money they have invested), and they make R200 in profit, their ROCE would be 20% (R200 divided by R1000, times 100). A higher ROCE means that a company is making more profit with the money it has invested, which is a good thing for investors.
Free Cash Flow (FCF) is a measure of how much cash a company has left over after it has paid for all of its expenses, including any money it needs to invest in the business to keep it running.
Let’s use the concept of a lemonade stand for simplicity.
Imagine you make R5000 in sales and it costs you R3000 to buy lemons, sugar, cups, and pay for the stand. You also need to pay yourself R500 for all your hard work. That means you have R1500 in cash left over.
Now, let’s say you want to use some of that cash to buy a new sign for your stand that costs R1000. If you spend that money, you will only have R500 left over. That’s similar to what a company has to do when it invests in new equipment or pays off debt.
To calculate FCF, you need to subtract a company’s capital expenditures (money spent on long-term investments like buildings, equipment, or new products) from its operating cash flow (money generated by its business operations). This gives you the amount of cash that the company has left over after it has taken care of its expenses and invested in its business.
So, FCF = Operating Cash Flow – Capital Expenditures
Investors use FCF to see how much cash a company has available to pay dividends to shareholders, pay off debt, or invest in new opportunities.
Overall, FCF is a good measure of how much cash a company generates and how well it manages that cash. It’s important for companies to have positive FCF, meaning they are generating more cash than they are spending, in order to stay financially healthy and grow their business over time.
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