Category: Basics

Free Cash Flow

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Free Cash Flow = Cash Flow from Operations – Capital Expenditure

Rough benchmarks for analysing a firm’s Free Cash Flow

You may also like to learn more on valuation techniques that use cash flow measures, as below.

Return on Invested Capital (ROIC)

Return on Invested Capital (ROIC) is a sophisticated way of analysing a stock for return on Capital that adjusts for some peculiarities of ROA and ROE. Its worth knowing how to interpret it because its overall a better measure of profitability than ROA and ROE. Essentially ROIC improves on ROA and ROE because it puts debt and equity financing on an equal footing. It removes the debt related distortion that can make highly leveraged companies look very profitable when using ROE. It also uses a different definition of Profits than ROE and ROA, both of which use Net Profits. ROIC uses Operating Profits after taxes, but before interest expenses (PBIT)

Again, the goal is to remove any effects caused by a company’s financing decisions -does it use debt or equity?- so that we can focus as closely as possible on the profitability of the core business.

The true operating performance of a firm is best measured by ROIC, which measures the return on all capital invested in the firm regardless of the source of the capital. The formula for ROIC is deceptively simple

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ROIC =Net Operating Profit after Taxes (NOPAT)/Invested Capital

Invested Capital =Total Assets – Non-Interest bearing Current Liabilities – Free Cash Flow

(Non-interest bearing current liabilities usually are Accounts Payable and other Current Assets)

You may also want to subtract Goodwill, if it’s a large percentage of Assets.

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What does all this mean to you if you hear someone talking about ROIC? Simply that you should interpret ROIC just as you would ROA and ROE – a higher Return on Invested Capital is preferable to a lower one!

Rough benchmarks for analysing a firm’s ROIC

In general, any non-financial firm that can generate consistent ROICs above 15 percent is atleast worth investigating. As of mid 2008, only about 10% of the non-financial firms listed in NSE were able to post an ROIC above 15% for each of the past 5 years, so you can see how tough it is to post this kind of performance. And if you can find a company with consistent ROICs over 30%, there’s a good chance you are really onto something.

You may also like to learn more on other returns-linked profitability measures, as below.

Return on Equity (ROE)

Return on Equity (ROE) is a great overall measure of a company’s profitability because it measures the efficiency with which a company uses shareholders’ equity. Think of it as measuring profits per rupee of shareholders’ capital.

As a rule of thumb, firms that are consistently able to post ROEs above 20% are generating solid returns on shareholders’ money, which means they are likely to have economic moats. Significantly, Return on Equity can tell us more than just the efficiency of using shareholders capital. ROE provides a direct peek into how well a firm balances – profitability, asset turnover and financial leverage – to provide decent returns on shareholders’ equity.

This is because there are only three levers for boosting ROE – Net Margin, Asset Turnover and Financial Leverage. Let’s see why this is so by examining the return on equity formula.

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ROE = Earnings/Shareholders’ Equity

Alternatively expressed as ROE = (Earnings/Sales) x (Sales/Assets) x (Assets/Shareholders’ Equity), or

ROE = Net Margin x Asset Turnover x Financial Leverage

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So we have three levers that can boost Return on equity -net margins, asset turnover, and financial leverage. For example, a firm can have only so-so margins and modest levels of financial leverage, but it could do a great job with asset turnover (e.g. a well run discount retailer). Companies with high asset turnover are extremely efficient at extracting more rupees of revenue for each rupee invested in hard assets. A firm might have asset turns only middling, and the firm might not have much leverage, but say it has great profit margins (e.g. a luxury goods company) – that would make for decent ROEs. Finally, a firm can also boost its ROE to respectable territory by taking on good-size amounts of leverage (e.g mature firms such as Utilities).

Calculating Return on Equity

Return on Equity is simply calculated by dividing Profit after Tax (annual earnings) divided by Shareholders’ Equity. Profit after Tax can be taken from the Profit and Loss Statement from the firm’s Annual Reports. The Shareholders Equity can be found in the Balance Sheet filed in the firm’s Annual Reports. Annual Reports can usually be found at the firm’s website or from SEBI EDIFAR database. Shareholders Equity is simply the difference between Total Assets and Total Liabilities – the assets that the business has generated.

Rough benchmarks for analysing a stock’s ROE

In general, any non-financial firm that can generate consistent ROEs above 15 percent without excessive leverage is atleast worth investigating. And if you can find a company with the potential for consistent ROEs over 30%, there’s a good chance you are really onto something.

Two Caveats when using ROE to analyse stocks

First, Banks always have enormous financial leverage ratios, so don’t be scared off by a leverage ratio that looks high relative to a non-bank. Additionally, since banks’ leverage is always so high, you want to raise the bar for financial firms – look for consistent ROEs above 18% or so.

Second caveat is about firms with ROEs that look to good to be true, because they are usually just that. ROEs above 50% or so are often meaningless because they have probably been distorted by the firm’s financial structure. Firms that have been recently spun off from parent firms, companies that have bought back much of their shares, and companies that have taken massive charges often have very skewed ROEs because their Equity base is depressed. When you see an ROE over 50%, check to see if the company has any of these above-mentioned characteristics.

You may also like to learn more on other return-linked profitability measures, as below.

Return on Assets (ROA)

ROA tells an investor how much Profit or Return a company generated for each Rupee of Assets.

Formula for Return on Assets

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ROA = Earnings/Assets Alternatively, this can also be expressed as ROA = (Earnings/Sales) x (Sales/Assets), or

ROA = Net Margin x Asset Turnover

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The first component of Return on Assets is simply Net Margin, or Net Income divided by Sales. It tells us how much of each Rupee of Sales a company keeps as Earnings, after paying all the costs of doing business.

The second component is Asset Turnover, or Sales divided by Assets, which tells us roughly how efficient the firm is at generating Revenue for each Rupee of Assets.

Multiply these two, and we have the formula for Return on Assets.

Utility Value of Return on Assets

ROA helps us understand that there are two routes to obtain excellent operational profitability. The company can charge high prices for its products (high margins) or it can turn over its assets quickly.

When using ROA as a comparative measure it is best to compare it against a firm’s previous ROA numbers or the ROA of a similar company. ROA for public companies can vary substantially and will be highly dependent on the industry.

Calculating Return on Assets

Calculate ROA by simply dividing Profit after Tax (annual earnings) by Average of Total Assets. Calculate Average Total Assets for any fiscal period by adding Total Assets for the fiscal and the previous fiscal and divide by two. Profit after Tax can be taken from the Profit and Loss Statement from the firm’s Annual Reports. The firm’s Total Assets can be found in the Balance Sheet filed in the firm’s Annual Reports. Annual Reports can usually be found at the firm’s website or from SEBI EDIFAR database. Total Assets refers to all the resources a company has at its disposal – the shareholders capital plus short and long term borrowed funds.

Rough benchmarks for analysing a firm’s ROA

All things being equal, the more asset-intensive a business, the more money must be reinvested into it to continue generating earnings. This is a bad thing. If a company has a ROA of 20%, it means that the company earned Rs. 20 for each Rs. 100 in assets. As a general rule, anything below 5% is very asset-heavy [manufacturing, railroads], anything above 20% is asset-light [advertising firms, software companies].

You may also like to learn more on other returns-linked profitability measures as below.