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There are many ways to sift financial data as part of a stock-selection process. One method is to look at companies’ returns on invested capital as a measure of how efficiently a management team has deployed investors’ money. But complicated accounting rules can distort the numbers.
Below are the results of a screen of the S&P 500 SPX using returns on invested capital as calculated by New Constructs, an investment data and research firm founded by Chief Executive David Trainer in 2002.
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A company’s return on invested capital (ROIC) is its profit divided by the sum of the carrying value of its common stock, preferred stock, long-term debt and capitalized lease obligations.
The carrying value of a company’s stock may be much lower than its current market value. The company may have issued most of its shares many years ago at a price much lower than today’s price. If a company has issued a relatively large amount of shares recently, or at high prices, its ROIC will be lower. If a company has low debt, its ROIC is higher. If a company is being forced to increase borrowings, its ROIC will fall.
Making the best use of ROIC means taking into account all the ways the data can be distorted under standard accounting practices, which is where New Constructs comes in. The firm defines ROIC as net operating profit after tax (NOPAT) divided by adjusted ROIC. Here is the firm’s definition of NOPAT and here is a summary of 30 adjustments New Constructs makes to NOPAT as part of its investment analysis and ratings service.
A critical factor in distorting ROIC numbers is that write-downs of goodwill and other items years or even decades ago can distort ROIC calculations for the most recent periods. During an interview with MarketWatch in October, Trainer explained that if a company writes down the value of any of its assets, such as acquisitions it may have paid premium prices for, it books noncash losses at that time, and the result is that the invested capital “disappears.”
Invested capital should include “all the capital that has been invested” through a company’s life, Trainer said. Here is an explanation of all the adjustments New Constructs makes to add write-downs and other items back into invested capital. This is painstaking work that has involved the review of notes below financial statements in corporate filings going back as far as 1986, Trainer said.