Understanding Compounding: The Importance of ROIC
“The higher return a business can earn on its capital, the more cash it can produce, the more value is created. Over time, it is hard for investors to earn returns that are much higher than the underlying business’ return on invested capital.” Warren Buffett
What is ROIC?
When we buy a business intending to hold it for the long term, we are looking for a company that will compound and grows our equity value. A business will grow as long as it has the potential to generate cash flows in the future.
Here we can trace the distinction between a “growth” and “value” stock. Shortly, growth has the majority of its present value derived from future cash flows. Value has the majority of its value-priced in the present, by its current fundamentals.
Growth investors aim to buy businesses with unlimited upside, with lots of optionality and possibilities of accelerating growth (growing more and/or longer than what the market expects).
Value investors focus on mispriced companies (e.g., businesses where the fundamentals, discounted by some valuation technique, point to a much more valuable business than what the market is pricing in).
“What we really want to do is buy a business that’s a great business, which means that business is going to earn a high return on capital employed for a very long period of time, and where we think the management will treat us right.” Warren Buffett
These definitions can be confusing, and some investors are skeptical of them. One apparent reason is that if you stress the purposes, growth investors are also looking for devalued businesses. The difference comes from the fact that one group is trying to evaluate the future. The other is focusing more on the present (and discounted heavily in the future).
Whatever the investor category you fit in, if you invest (and investing per see means holding for the long-term), you want to achieve multi-bagger returns via compounding.
To measure management’s skill in allocating capital into growth, we use the Return on Invested Capital.
“If you earn high enough returns on equity and you can keep employing more of that equity at the same rate — that’s also difficult to do — you know, the world compounds very fast.” Warren Buffett
Return on Invested Capital (ROIC) gives us a sense of how well a company is using its capital (debt and equity) to generate profits without the effects of debt (e.g.,: debt repayment).
“The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine.” Warren Buffett
Why is it useful?
The ROIC is essential because, in the end, as stock pickers, we are trying to get a piece of compounding machines, and compounding comes from constant and growing cash generation by a business. Management’s skill in allocating capital is crucial for that, and the ROIC can be seen as a measure for that.
“Looking back, when we’ve bought wonderful businesses that turned out to continue to be wonderful, we could’ve paid significantly more money, and they still would have been great business decisions. But you never know 100 percent for sure. And so it isn’t as precise as you might think. Generally speaking, if you get a chance to buy a wonderful business — and by that, I would mean one that has economic characteristics that lead you to believe, with a high degree of certainty, that they will be earning unusual returns on capital over time — unusually high — and, better yet, if they get the chance to employ more capital at — again, at high rates of return — that’s the best of all businesses. And you probably should stretch a little.” Warren Buffett
How do I know if the ROIC is high or low?
“If you have a business that’s earning 5 or 6 percent on equity and you hold it for a long time, you are not going to do well in investing. Even if you buy it cheap to start with.” Warren Buffett
As a rule of thumb, if ROIC is higher than the discount rate, the company is creating value, whereas if it is lower, it is destroying value.
“We like to think when we buy a stock, we’re going to own it for a very long time, and therefore we have to stay away from businesses that have low returns on equity.” Warren Buffett
The discount rate here would be the WACC. Still, because we cannot be very precise with financial calculations, you should have a margin of safety as a heuristic. Picking businesses with future ROICs way above-market returns and interest rates. In my case, I only add to my portfolio a stock that I believe can sustain ROICs above 15% for the long term.
ROIC and ROE
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return — even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.” Charlie Munger
The Return on Equity gives us the profits a company can generate for each dollar of equity in its balance sheet. It is focused on equity allocation without taking into account debt.
“A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital.” Warren Buffett
Companies have incentives to hold debt because they can have tax advantages with it. Management is usually trying to optimize capital structure with debt and equity.
“Time is the enemy of the poor business, and it’s the friend of the great business. I mean if you have a business that’s earning 20 or 25 percent on equity, and it does that for a long time, time is your friend.” Warren Buffett
Why are we using NOPAT instead of Net Profit?
The Net Operating Profit After Taxes (NOPAT) is a measure of performance for the company’s core operations, net of taxes. It could also be read as the potential cash earnings if its capital structure were unleveraged (no debt).
We use NOPAT instead of Net Profit with the ROIC calculation to measure the company’s results without debt. We are trying to isolate operating profit after taxes to compare with the Invested Capital within the business. The NOPAT also helps exclude one-time sources of income non-related to the core business.
NOPAT does not include the tax savings many companies get because of existing debt.
“The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with ‘Roman Candles’, companies whose moats proved illusory and were soon crossed.” Warren Buffett
Conclusion
The ROIC ratio gives a sense of how well a company uses the money it has raised externally to generate returns.
Return on invested capital (ROIC) assesses a company’s efficiency at allocating the capital under its control to profitable investments or projects. Comparing a company’s return on invested capital with its weighted average cost of capital (WACC) reveals whether invested capital is being used effectively.
“Bear in mind — this is a critical fact often ignored — that investors as a whole cannot get anything out of their businesses except what the businesses earn. Sure, you and I can sell each other stocks at higher and higher prices.” Warren Buffett
