Returns on invested capital (or ROIC) and the firm’s cost of funding

NIKE, Inc. (NKE) has successfully built a cult brand whose new products sell out within minutes of hitting the stores. The firm has also demonstrated its pricing power. The must-have aura about its products have helped the company earn consistent above-average returns, over and above its capital costs.

Why The NIKE Brand Consistently Delivers Above-Average Returns

NIKE’s above-average returns

NIKE’s favored yardstick for measuring returns is the return on invested capital (or ROIC). The ROIC measures how much cash flow is generated by a firm’s investments. It’s calculated by taking net operating profits less adjusted taxes, and dividing that by invested capital. Capital investments include those financed by both debt and equity.

The difference between the ROIC and the firm’s cost of funds,[1. weighted average cost of capital or WACC] determines the excess economic value generated by the firm, over and above its cost of funds. A greater difference implies higher value and vice versa. As you can see in the chart, NIKE’s ROIC was higher and its weighted average cost of capital (or WACC) was lower than the average among its competitors. This suggests that NIKE has generated higher economic value.

NIKE’s competitors include United Armour Inc. (UA), VFC Corporation (VF), Lululemon Athletica Inc. (LULU), and Adidas AG (ADDYY). United Armour, VFC, and NIKE are part of the Vanguard Total Stock Market ETF (VTI), the SPDR Consumer Discretionary Select Sector ETF (XLY), and the SPDR S&P 500 ETF (SPY)

Strategy going forward

NIKE is determined to generate higher positive cash flow and maintain ROIC in the mid-twenties range going forward. The company’s strategy hinges on a couple of things:

  • Better working capital and inventory management
  • Capital expenditure targeted at higher return investments—for example, retail store rollout, digital and e-commerce, and innovation

So far, NIKE is on track to meet its goals. ROIC came in at 26.2% in 1Q15, an increase of 0.7% over last year. As you can see in the graph Part 17, the difference between the ROIC and NIKE’s cost of capital appears to be widening, which suggests economic value is increasing. The next part of this series will explain why.

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