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As investors, we want to try and search for great businesses to own and that’s because doing so can often help lead us to obtain superior longer-term returns.
Yet, how can we quantify what a good business looks like? 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 a 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 needs a large capital investment of $5 million (US$4.5 million to acquire the property and $500,000 for working capital) to start.
Baba, on the other hand, is situated on the outskirts of town and thus requires 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 an 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.
ROIC is a useful metric to help investors find higher-quality companies. In general, a high ROIC will mean a solid business while a low ROIC will point to a business of low quality.
This is important for investors as higher-quality businesses tend to deliver more sustainable returns over the long term.
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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 Hong Kong contributor Lawrence Nga doesn’t own shares in any companies mentioned.