As investors, we may want to try and search for good businesses and that’s because doing so can often help lead us to good investments.
Yet, how can we quantify a good business? Is there a metric that investors can use to tell the difference between a high quality and low quality business? I believe there is, and it is a metric known as the return on invested capital, or ROIC. Here’s the math needed:
To understand ROIC, let’s imagine there are two coffee shops, Ali and Baba. Both shops currently have annual sales of $1 million and profit of $200,000 each. Based on the revenue and profit figures, both coffee shops look equally good.
But, Ali is located in the city centre and needed a large capital investment of $5 million ($4.5 million to acquire the property and $500,000 for working capital) to start.
Baba, on the other hand, is situated in the outskirts of town and thus required only $1 million in capital investment ($800,000 to buy the shopfront and $200,000 for working capital).
Using the above formula, the ROIC for Ali is just 4 % whereas Baba’s is 20%. We can therefore conclude that Baba is a better-quality business since it requires less capital to generate the same amount of profit.
So, put simply, ROIC is used to understand whether a business is good, average or bad. An average business generally has a ROIC of between 12% and 15%. Thus, a rule of thumb is that anything above 15% is considered a good business and anything lower than 12% is of low quality.
Comparison of ROIC of two companies
Let us now do a simple comparison of the ROIC between two well-known companies in Singapore, namely, logistics and mail services provider Singapore Post Limited (SGX: S08) and the carrier Singapore Airlines Ltd (SGX: C6L). We’d be looking at the numbers from the companies’ last completed fiscal years.
In terms of revenue, Singapore Airlines is 16 times the size of Singapore Post whereas its profit before interest and tax is only twice as large.
The ROIC of Singapore Post is nearly six times that of Singapore Airlines, which means that every dollar of capital invested in Singapore Post will generate six times the profit when compared to the same dollar invested in Singapore Airlines.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Lawrence Nga doesn’t own shares in any companies mentioned.