What is the objective of a business?

Nearly everyone will work for a business at some point in their life. But what is the objective of a business?

It's not to maximize net income, revenue, market share, or EBITDA, although these are all nice things to have. The objective of a business is to maximize Return on Invested Capital (ROIC). ROIC is the preferred metric of Michael Porter (often considered the "godfather" of modern business strategy and the creator of "Porter's Five Forces") and Warren Buffett (without a doubt one of the greatest investors of our time).

But what is ROIC, and why is it the best way to measure the success of a business? First, let's define what ROIC is.

How to calculate Return on Invested Capital (ROIC)

ROIC = Net Operating Profit After Tax (NOPAT) / Invested Capital.

Let's break this down. First, let's start with Net Operating Profit After Tax (NOPAT). To get a company's NOPAT, we must look at its Income Statement.

• Start with its Revenues and subtract out the Cost of Goods Sold (COGS). (Note: COGS is sometimes called Cost of Revenue). This yields Gross Profit.

• Next, subtract out all of the company's Operating Costs (e.g., Research and Development (R&D) costs, Selling, General, and Administrative (SG&A) costs, depreciation, amortization, etc.). This yields Operating Profit.

• As a last step, we must derive the company's tax rate for the period. We can calculate this by dividing the company's Provision for Income Tax by its Pretax Income. This yields the company's effective tax rate.

• We can now perform the following calculation: Operating Profit x (1 - Effective Tax Rate). This yields the company's Net Operating Profit After Tax (NOPAT).

Next, let's break down Invested Capital. At a high level, Invested Capital is the sum of a company's debt and equity. If that doesn't make sense to you, think about it this way. Suppose you own a house. The house you own is an asset. To purchase this asset, you likely used a combination of debt (in this case, a mortgage) and equity (a down payment).

Companies work the same way. Everything a company owns - its offices, equipment, factories, inventory - are its assets. All of these assets are financed through a combination of debt (from banks and bondholders) and equity (from stockholders).

To calculate Invested Capital, we need to look at a company's Balance Sheet. While there are a couple of ways to calculate Invested Capital (i.e., the "operating approach" and the "financing approach"), I personally prefer a simplified version of the "financing approach" (outlined below). If you work in investment banking or private equity, you might want to use the "operating approach" or a more nuanced version of the "financing approach"; however, I'm all for simplicity over perfection, and I believe the approach below is as intuitive and simplistic as it gets.

To calculate Invested Capital using my simplified "financing approach":

• Start by finding the company's Total Liabilities. This is basically what the company owes to external parties. From this section, we want to add the company's short-term and long-term debt. This is what banks and bondholders have invested in the business.

  • Note: sometimes, a company's short-term debt is just the "current portion of long-term debt." To find the current portion of long-term debt, you'll have to dig through the company's quarterly or annual SEC filings to see how much of the long-term debt is due within the next 12 months.

• Next, find the company's Total Equity. For instance, when a company "IPOs," it raises equity. Equity from that capital raise is reflected here (as additional paid-in capital), as is the company's accumulated profit/loss (retained earnings) and any share buybacks it has executed (treasury stock).

• Add the sum from the liabilities section (Short-Term Debt + Long-Term Debt) and Total Equity to get Invested Capital.

We can now divide the company's NOPAT by its Invested Capital to get its ROIC.

The value of looking at ROIC vs. other financial and operating metrics

So, why is ROIC the best measure of how a business is performing? There are a few reasons:

1. It's investor-focused. A company is ultimately funded by investors, both "debt" investors (bondholders) and "equity" investors (shareholders). ROIC measures returns relative to the debt and equity capital these investors have provided. While other financial and operating metrics in a business are certainly important (e.g., Revenue, Gross Profit, Gross Profit Margin, Operating Profit, Operating Profit Margin, Inventory Turnover, etc.), none of these metrics compares a company's financial returns relative to what's invested in the business.

   
   

   Think about it this way. If you invest your money in stocks and bonds, do you care how much money you make in a year, or do you care how much money you make in a year relative to how much you invested (i.e., your investment rate of return)? While you likely care about both metrics to some degree, if you want to compare your performance to that of other investors, you'd rather look at your investment rate of return.

   
   

2. It's capital structure neutral. When companies finance themselves, they can decide how much of their assets to finance with debt and how much to finance with equity. The proportion of debt and equity a company chooses is its "capital structure". It's not uncommon to see companies within the same industry with different capital structures.

   
   

   So, if you want to look within an industry to see which company is doing the best, ROIC is the best metric because it is capital structure neutral in two ways. First, the numerator, NOPAT, ignores a company's interest (debt) expenses. Second, the denominator, Invested Capital, examines all of a company's invested capital, not just that of debt investors or equity investors (this is why metrics like Return on Equity are not as valuable as ROIC). Combined, this makes ROIC a capital structure-neutral metric.

   
   

3. It can tell you whether a company is "value-creating" or "value-destroying". If a company's ROIC is greater than its WACC (Weighted Average Cost of Capital), then it is value-creating. However, if its ROIC is less than its WACC, then it is value-destroying.

   
   

   Why is that? Let's consider an example. Suppose a business decides to raise a mix of debt and equity capital from investors at an average cost of 8%. This is its "WACC". This business then takes this capital and earns a ROIC of 14%. In other words, for every $100 investors put into the business, on average it costs the business $8 and it generates $14. Thus, the business is "value-creating", since its output ($14) is greater than its input costs ($8).

   
   

   On the contrary, if the business has the same WACC of 8% but generates a ROIC of only 6%, then it is "value-destroying", since for every $100 investors put into the business, it will cost the business $8 but it will only generate $6. So, in this instance, the output ($6) is less than the input costs ($8).

Conclusion

The next time you are considering investing in a business, calculate its ROIC. Observe how the company's ROIC has changed over time (hopefully, it's trending up!) as well as how its ROIC compares to competing firms within its industry.

Given the objectivity and value of ROIC, it's no wonder it's one of Porter's and Buffett's preferred metrics when analyzing a business.