Revisiting Return on Invested Capital

As I mentioned in an earlier post ("From Joel Greenblatt to Jim Rogers, Part I: The Magic Formula"), Return on Invested Capital (ROIC) is one of the two metrics that comprise Joel Greenblatt's Magic Formula.

A question raised on the Magic Formula Investing Yahoo! Message Board led to a discussion that highlighted the limitations of this metric. The question was why KSW, Inc. (Nasdaq: KSW), a micro cap HVAC contractor, was no longer on the Magic Formula list. One of the message board's moderators, Marsh Gerda (who also writes an MFI Diary blog) and I separately calculated the Magic Formula metrics to see if we could figure out why the company was no longer on the list.

Greenblatt's Formula for ROIC

Recall from the previous post on this that Greenblatt's formula for ROIC is EBIT¹/(Net Working Capital + Net Fixed Assets).

My ROIC Calculation for KSW

KSW is a $29.4 million market cap company with no debt and $17.75 million in net cash on its balance sheet. Using the standard definition of Net Working Capital (Current Assets - Current Liabilities), I got an ROIC of 38% for KSW. Using that standard definition of Net Working Capital made intuitive sense to me, because it put KSW's excess cash in the denominator of the ROIC formula, so holding so much excess cash reduced the company's return on invested capital.

Marsh Gerda's ROIC Calculation for KSW

Marsh Gerda used Greenblatt's more idiosyncratic definition of Net Working Capital, which excludes a company's excess cash, to calculate KSW's ROIC. He got an ROIC of 1757% for KSW. It appears that he calculated this the right way (with respect to the Magic Formula method) and I calculated it the wrong way, by ignoring Greenblatt's different definition of Net Working Capital.

What The Numbers Mean

Theoretically, an ROIC of 1757% means that, for every additional dollar of capital a company invests in its business, it can earn $17.57 in earnings. In reality, of course, there are a couple of problems with this. First, if a company could really earn 1757% on its cash by investing that in its business, it wouldn't be holding most of its market cap in cash, where, presumably, it is earning less than 4% in annual interest. This would be a problem using my calculation of ROIC as well: 38% may be a lot less than 1757%, but it's still almost an order of magnitude more than the company can earn on its cash.

The second problem is that the amount of capital KSW can profitably reinvest in its business appears to be limited, for a few reasons:

- As an HVAC contractor, it requires little tangible capital, so it can't simply spend a lot of additional capital on new plant and equipment.
- Theoretically, it could use additional capital to expand into other cities (most of KSW's business is in NYC), but the commercial construction business is highly local: a contractor needs relationships with local developers, politicians, etc. (KSW could perhaps get around this by acquiring an HVAC contractor in a different city, but it may not have enough information about that city's construction industry to be an intelligent buyer, and it may not have enough cash to make a suitable acquisition).
- As a construction contractor, KSW probably has to pay up front for supplies and labor before it gets paid on a project. It make sense for the company to hold a certain amount of cash to cover these upfront costs, particularly when credit is less available, and more expensive (especially the sort of construction factoring the company would likely have to rely on).

Similar real-world constraints prevent other companies with theoretically high returns on invested capital from reinvesting most of their cash in their respective businesses. This frequent inability of profitable companies to invest most of their excess cash in their core businesses leads in some cases to the companies returning that cash to shareholders, via dividends or buybacks, and in other cases, to spending that cash on acquisitions (sometimes of businesses that are less profitable than the acquiring company's core business).

¹Earnings before Interest and Taxes