What The Heck Is CROIC?

July 17, 2007 by Joe Ponzio

Perhaps one of the most important, and least used, numbers on Wall Street is CROIC-Cash Return On Invested Capital. A Google search for “earnings in investing” brings up some 7 million results. “CROIC in investing” brings up 47, of which 5 belong to F Wall Street (probably six after this post).

As I promised Oliver on July 13th, let’s explore CROIC for a minute.

CROIC vs. ROIC

Return On Invested Capital (or ROIC) is Wall Street’s way of measuring of how effectively a company uses the money (borrowed or owned) invested in its operations. Huh? Okay-ROIC is supposedly a way to tell if a company is allocating money properly. But ROIC has a major flaw-it is based on earnings. What good is a calculation that is based on such an unreliable, nonsense number?

Cash Return On Invested Capital (or CROIC) tells us how much cash our company can generate based on each dollar it invests into its operations. When a company generates cash, it has two choices-pay it out to shareholders or reinvest it for growth. CROIC tells us if our company is doing a good job reinvesting cash for growth, or if management is hording cash when it should be letting us reinvest it elsewhere.

The CROIC Calculation

CROIC = Free Cash Flow divided by Invested Capital. Invested Capital is a combination of the company’s net worth and any long-term debt it uses. CROIC is expressed as a percentage so that you can compare apples to apples when looking at companies of different sizes. You can see the calculation to the right.

What Is A Good Level Of CROIC?

The higher the CROIC, the better. I prefer to see CROIC above 13%. Any lower, and the numbers begin to get fragile. Fragile turns into unreliable. Unreliable leads to lackluster growth.

What About Berkshire’s CROIC?

If you recall from this post, Berkshire’s CROIC is less than 4%. Does that mean that Buffett and Munger are doing a poor job of allocating capital? No way. They’re the best. However, even Buffett himself has said that Berkshire’s growing asset base is making it more difficult to find suitable investments and that he does not expect Berkshire’s future growth to continue as it has in the past.

Growth comes from generating enough cash to do so. The more Berkshire (or any company) grows, the more difficult it is to continue that growth. Think about this: If you invested $10 and got back $15, you earned 50% on your invested capital. Had you invested $1,000 and earned $5, your CROIC was 0.5%.

Will Wall Street Catch On To CROIC?

Probably not. Wall Street is built on selling investments based on the underlying companies’ tax return figures (see The Importance Of Earnings). As much as possible, Wall Street wants to keep your eyes away from CROIC and Free Cash Flow. Why? Most companies have roller coaster free cash flow and low CROICs.

If investors focused on what really mattered when analyzing a company, Wall Street wouldn’t be able to sell 90% of their products.

A Note From Joe Ponzio

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