What is CROIC?

What is CROIC:

I use CROIC and I love it.. No it’s not some ugly plastic shoes that should be banned from all humankind. It’s Cash Return On Invested Capital and if I had to choose any one specific measure to test the competence of management and strength of the company this would be it. CROIC in investing is basically the return on cash the company is able to generate with the cash it receives from shareholders and other debtors. As a percentage this gives us an idea of how efficient management is at reinvesting it’s invested capital in-order to generate more cash.

Why I use this measure:

I like to use this measure in order to give me a picture of management. I am not much of a dividend fanatic for several different reasons, taxes being just one of them. However, if management is not able to generate good returns on capital than I see there to be no reason not to pay dividends. If a company like Black and Decker decides not to pay dividends, for me that is fine as they usually can get between 15-20% returns on their investments. That to me is a great return on capital. I would be hard pressed to get that on my own investments. I use the CROIC to gage just how healthy and competent management is at reinvesting it’s capital. Can I do a better job? I don’t like to see anything less than 12% CROIC, this usually tells me the company has a strong moat, or at-least some kind of advantage.

How to calculate:

CROIC is fairly simple to calculate and even easier to understand. Keep in mind when calculation CRIOC in investing we want to look mainly at the long term debt, not short term. We do this because short term liabilities that a company has are often loans for short term cash flow issues. Many companies take short term loans to cover day to day cost because the credit time on accounts receivable is longer than accounts payable. Say 40 days for accounts receivable and 20 days for accounts payable: hence 20 days short term cash flow issues.

I like to look at Morningstar.com where when you look for a stock quote you get these values on the first page. Here is a little print out and how to calculate CROIC:

For 2007 the CROIC would be: 857/3025+629-628 = 28%

2008: 1157/3715+810-611= 29,5%

2009: 1029/4115+1082-818 = 24%

CROIC average over the 3 year period: 28%+29,5%+24%/3 = 27,17%

Of course a 3 year period is to short to draw any kind of conclusions, but we can guess here that this company has been amazing at reinvesting it’s cash. 27% is above average, which means they have some kind of moat that allows them to get such high returns on invested capital. In this particular case the company is a pharmaceuticals, which means their moat is based on Patents. Pretty strong moat, but time limited. To evaluate this company further we have to figure out how long those patents are good for and how many such patents they have and what percentage of income each patent has.

How to use CROIC:

Now keep in mind that just because a company has a high CROIC does not mean the company is a great investment, it is a start. If a company has a negative CROIC and no turn around in site, then it is probably a company you should avoid. Once you have a company you like with a high CROIC <12% then you need to compare this to other companies in the same industry. Most car manufacturers and airlines have negative CROIC. So finding an airline with a positive CROIC over many years is probably a great company to research deeper.

Once you have compared the company with other companies in the same industry than it comes down to figuring out why the CROIC is so high. In the example above we came to a 27% 3 year average, they have a strong moat. This moat is based on drug patents, which are due to expire in 3 years time. Is this company still as good?

Summary:

CROIC is only a small portion of the whole picture, so use it with regard to the other key metrics such as P/E, P/S, P/B and so on. While it does not give a total picture it strengthens the picture and gives credibility to management. In order for me to invest my cash in a company, the company must have a CROIC of higher than 12%.

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