Wednesday, 5 September 2012

Investopedia - A great reference tool...but don't trust it completely

Investopedia is one of the greatest investing resources on the internet - it is one of the most comprehensive, easy to use investment websites.  It's strength does not come from it's financial articles and analysis (there are plenty of sites that have better material) however it is one of the best resources for looking up terminology and formulas availabel on the internet - it is one giant dictionary for finance.

If you use the search tool for almost any financial term it will come up with an explanation and if relevant a formula as well as a brief description of the inputs (note that if you dont understand the inputs then you can look these up too).

The problem with the site though is that there are occasionally errors and if you don't spot them you can make pretty big mistakes

For example Investopedia defines return on invested capital (ROIC) as

However this defintion doesnt really make sense.  The return on invested capital is either used to describe ther return on the assets (ROA) or return on capital invested (i.e. ROE).  The definition they have above moulds the two together to give a non sensical answer.

That is Investopedia's definition of ROIC uses a geared numerator and an ungeared denominator.  Why is this a problem you may ask?  Well consider the following scenario. 
  • You have a company which has a certain ROIC (calculated in the above way). 
  • The company issues more equity to pay down debt (i.e. the way in which the assets are funded changes but the total amount of funding doesnt change. 
  • Your demoninator stays the same (as the invested capital doesnt change - just the composition) but the Net profit actually increases because there is a lower finance charge. 
  • Assuming the dividend rate is lower than the interest rate (which it normally is) you get an increase in ROIC based on how the business is funded not how the assets are performing
This is a pretty fundamental (and rookie) error on Investopedia's behalf.  The problem is not only limited to individuals using this site

If you automatically assume that Investopedia is right and do not sense check what they are telling you then you may make embarrasing mistakes

This was certainly the case for Toll Holdings, one of the largest listed companies in Australia with billions of dollars in revenue and a market capitalisation of ~A$3.3 billion (US$3.4 bililon).  Someone in their investor relations department did not think about the definition of ROIC too closely (and I think probably just got the definition off Investopedia) and put the following slide in their presentation.

If you look at their definition of ROIC - it is exactly the same definition as that used by Investopedia.  In case you're thinking that this is actually the right answer and it is just a funny metric - Brambles, another large Australian listed corporate also discloss ROIC but if you look at their note below you will see that it has the correct definition (compared to Toll's)

Summary - Investopedia is a great tool but make sure you sense check everything you take off there as it is not foolproof

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