What are the advantages of using ROIC (Return on Invested Capital) as a key financial metric for analyzing stocks compared to P/E (Price-to-Earnings ratio)? I'm particularly interested in understanding why ROIC might be more informative for assessing a company's financial health and investment potential, even though P/E reflects the stock price I'm considering when making an investment.
ROIC is a measure of how well a company has used its capital to generate returns. It can be used to compare the efficiency or effectiveness of similar companies, or to see if a company is making sufficient excess return over its cost of capital. It is always a backwards looking measure, while P/E can either be backwards-looking or forwards-looking, with forward-looking using projected earnings against the current price.
P/E is more commonly used for finding stocks that are "underpriced", signalling a potential value investment (relying more on mispricing than fundamentals). They are not always interchangeable, meaning a company can have a great ROIC but still be under-priced, and company with a low ROIC can still be priced high for other reasons.
Since these two metrics are closely related in the sense that a high ROIC will tend to mean a high P/E (and conversely) you cannot really consider one in preference to the other. Also, keep in mind that one years numbers can be distorted by one off events so you need have access to multiple years of data in order to make a sound judgement. Both ROIC and P/E must be taken in the context of factors like the sector and any associated risks such as interest rate or geopolitical risk.
Consider that the financial services industry employs tens of thousands of professional analysts who have access to much better data than your average individual investor and whose aggregate judgements largely determine the current market price. Spending a lot of time and effort searching for anomalies will most likely result in a lot of wasted time even if there are worse ways to spend your time.
There's an old saying in philosophy which is well suited to investing : "We learn enough to think that we are right, but not enough to know that we are wrong."
ROIC provides the necessary context for other metrics such as the price-to-earnings (P/E) ratio. Viewed in isolation, the P/E ratio might suggest a company is oversold, but the decline could be because the company is no longer generating value for shareholders at the same rate (or at all). On the other hand, companies that consistently generate high rates of return on capital invested probably deserve to trade at a premium compared to other stocks.