ROIC: My Quality North Star—And Why It’s Not One-Size-Fits-All

A Guide to Mastering ROIC for Quality Investments curated by a prior Finance Manager.

Welcome to Compound & Fire! We search for businesses which create strong shareholder value over time in order to get financial independence and retire early.

This community is free, but if you’d like to support my time in providing deep analysis, you can Buy Me a Coffee. Every contribution helps keep this community thriving and is highly appreciated!

Join our global quality investing app on Discord here and join my Substack for free if you haven’t subscribed yet.

Return on Invested Capital (ROIC) is my go-to metric for identifying quality companies. It measures how effectively a business converts its capital into profit, cutting through the noise of revenue growth or earnings manipulation. A consistently strong ROIC points to efficiency, a durable competitive edge, and the kind of investment quality I pursue.

Yet, ROIC isn’t a one-size-fits-all tool. Its application across diverse industries can lead to misinterpretations. Companies that grow through frequent acquisitions face distortions from accounting practices like goodwill and intangibles. Insurance firms, meanwhile, leverage float—a unique capital source—rather than traditional equity and debt. Recognizing when to adjust ROIC or pivot to alternative metrics is key to unlocking a company’s true value. Let’s explore these adjustments for serial acquirers and insurance companies, then consider when ROIC falls short.

Adjusting ROIC for Serial Acquirers

Serial acquirers—companies that expand by regularly purchasing other businesses—often see their financial metrics skewed by acquisition accounting. When a company buys another, the purchase price is split into tangible assets (e.g., physical equipment), identifiable intangibles (e.g., customer relationships or brand value), and goodwill—the premium paid above the fair value of those assets.

Intangibles contribute real economic value; customer relationships drive revenue over time, while brand value enhances market presence. Goodwill, however, represents future expectations—synergies, growth potential, or intangible benefits not tied to specific assets. Under international accounting standards, goodwill and certain intangibles with indefinite lives remain on the balance sheet unless impaired, tested annually to assess if their value has declined.

This accounting treatment complicates ROIC, calculated as earnings (NOPAT) divided by invested capital (typically equity plus debt). Goodwill inflates the capital base because it’s an accounting entry, not capital actively deployed like a loan or machinery.

For serial acquirers, this can mask their operational efficiency, as including the full goodwill value assumes it’s all currently productive—which isn’t true, especially for recent acquisitions where synergies are still unrealized. One-time costs, such as transaction fees, integration expenses, or strategic initiatives (e.g., exploring new market opportunities), further depress operating profit, pulling ROIC downward.

To refine ROIC, adjustments are necessary, a practice supported by valuation experts. In Valuation: Measuring and Managing the Value of Companies by McKinsey & Company, the authors suggest analyzing ROIC both with and without goodwill. The unadjusted metric measures a company’s ability to create value over acquisition premiums, while excluding goodwill isolates the core business’s performance, offering a clearer comparison across firms with differing acquisition strategies.

I start with a core earnings metric, like net profit after tax adjusted for non-recurring items and amortisation, plus cash interest to reflect operating returns before financing costs.

From the denominator, I consider excluding the full goodwill and intangibles initially, focusing on tangible capital, as these may not yet drive value. However, a partial adjustment often makes sense. For instance, if a company pays five times earnings for an acquisition—where earnings equal free cash flow (FCF)—the cash paid could theoretically be recouped in five years if the acquisition performs as expected. After this period, part of the goodwill might be seen as “matured,” contributing to profits, while the rest remains unproven. Deducting a portion of goodwill from invested capital reflects this reality, reducing the denominator to better match the capital actually generating returns.

Why only a part? Fully excluding goodwill might overstate ROIC, ignoring that some acquisitions do create value over time—evidenced by revenue growth or margin improvements. Leaving it all in, however, penalizes companies for strategic growth, especially serial acquirers with large goodwill positions. A balanced approach—say, counting half as matured based on the company’s integration track record—offers a practical compromise. But the percentage depends on the acquisition history of recent years and their goodwill versus total goodwill balance. It can take time for an acquired company to be fully integrated and for the acquirer to realize the expected synergies. In the short term, it might be reasonable to include goodwill in the ROIC calculation. However, over the long term, the company should be able to demonstrate that the goodwill is generating returns.

This isn’t standard in reported ROIC figures, as most companies present unadjusted metrics for simplicity or regulatory consistency, but for investors seeking quality, it’s a valuable lens, as McKinsey’s framework highlights. For serial acquirers, the goodwill burden is often higher due to frequent deals, yet I also value companies that avoid overpaying, managing acquisitions prudently to minimize goodwill inflation—a key quality filter.

Adjusting for Insurance Companies

Insurance companies present a different challenge. Their business model relies on float—premiums collected before claims are paid—which they invest to generate income. Traditional ROIC, based on equity and debt, struggles here because float isn’t conventional “invested capital”; it’s a liability. This misalignment causes ROIC to underrepresent their economic performance. In a recent article on Kinsale Capital Group (available here), I explained why I pivot to Return on Equity (ROE) instead, as it captures total profitability, including investment gains from float, offering a truer measure of an insurer’s strength.

For insurers, complement ROE with the combined ratio—comparing claims and expenses to premiums—to assess underwriting profitability, and track float growth to gauge their capacity to invest. These metrics reveal a company’s efficiency and scalability. ROIC, while useful elsewhere, misses this nuance, making it less relevant for insurance quality analysis.

Beyond ROIC: When It Falls Short

ROIC isn’t always the best tool. Asset-light businesses, like software firms, may show high ROIC due to low capital needs, but I’d prioritize robust gross margins and steady revenue growth to confirm their edge. Leveraged industries, such as utilities, can inflate ROIC with debt—here, Return on Capital Employed (ROCE) or interest coverage ratios provide clarity. Cash-rich companies, like large tech giants, may skew ROIC with excess reserves—adjusting by adding cash back or focusing on free cash flow yield refines the view.

Your Takeaway

ROIC is my north star, but context is everything. For serial acquirers, I adjust their reported ROIC by tempering the goodwill and intangibles impact, reflecting only the matured value to highlight operational quality, a method supported by valuation experts like McKinsey. For insurance companies, I shift to ROE and float metrics, as explored in my Kinsale article, to capture their unique value drivers. Knowing when to tweak ROIC—or choose a different metric—sharpens your investment insight.

What’s your preferred metric adjustment? I’m diving deeper on my new Discord—join me here to debate quality picks and share your strategies. Let’s compound that fire together.

Subscribe for more deep dives, and jump into the Discord for real-time discussion.