Is Your Company Making the Right Investment?
There are many ways to look at whether an investment is profitable. However, one of the primary profitability ratios our firm recommends to our customers is return on invested capital, or ROIC. ROIC is a useful tool when you want to compare a company’s profitability to its value-creating potential after taking into account a company’s initial capital investment.
The ROIC formula (see above) is a calculation used to assess a company’s efficiency at allocating the capital under its control to profitable investments. Return on invested capital gives a sense of how well a company is using its money to generate returns, per Investopedia.
Typically, our firm’s buy-side engagements begin by “riding” a prospective acquisition of retail sites with our client and senior management team. After the ride is completed, the client and PetroCapRE work together to develop the company’s initial acquisition assumptions. We then prepare a site-by-site acquisition model.
The model includes an income statement for each site, opening balance sheet, cash flow statement and various projected capital structures that could be used to close the acquisition. Most importantly, the model calculates the client’s expected ROIC based upon various capital structures and bid prices for the network of sites.
We use the calculation of ROIC to help companies more succinctly understand the internal rate of return that each type of capital structure provides, while at the same time providing a clearer picture of the associated risks or opportunities related to each potential financing structure.
For example, many times, operators are hesitant to bring on institutional investors and instead prefer equity partnerships. Although this can be understandable from a risk perspective, in the long run it may be much more profitable from a ROIC perspective to pay a higher interest rate in the early years and maintain 100-percent ownership, rather than pay a percentage of the profits in perpetuity.
Another structure we typically look at when helping our clients assess a transaction is: What is the ROIC of owning the real estate vs. entering into a sale leaseback?
We have seen that as companies become much larger, and depending on the cyclicality of financing, companies tend to finance their assets under a sale-leaseback method because it improves their ROIC. The ROIC of all financing structures changes dramatically depending on the character of the underlying assets and the cyclicality of the financial markets.
The bottom line is that if the ROIC regarding an investment — be it an acquisition, land purchase, equipment investment, etc. — does not meet or beat your expected return, unless there are other qualitative factors that cannot be calculated, you should look for better, more fruitful opportunities.