Return on Invested Capital (ROIC) - Why focus on it?

High quality businesses are those that can generate high returns on capital. But, outstanding businesses are those that can keep compounding their profits at high returns.

Charlie Munger famously said that if you invest in a business that can compound high returns on capital, you will likely outperform even if you overpay.

“We’ve really made the money out of high-quality businesses. 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 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.

So the trick is getting into better businesses. And that involves all of these advantages of scale that you could consider momentum effects”

Charlie Munger’s famous talk at USC Business School, delivered 1994

Sections:

1. Comparing investment returns
2. Return on Invested Capital
3. Reinvestment Rate
4. EBIT growth
5. The rise and fall of Blackberry

1. Comparing investment returns

Let’s compare a long term investment in the following companies: Google (Alphabet), Amazon, Costco or IBM, with a review of Blackberry maker RIM at the end.

For simplicity, we expect that each business maintains its current returns on capital and reinvestment rates over the next 20 years. We will purchase each company at its current trading price.

Starting with IBM, the business with the lowest returns on capital and reinvestment rates. If we were to sell IBM at a higher Price to Book Value multiple than we purchased, we will only achieve an annual investment return of 5%.

Now with Google and Amazon, the two companies with the highest returns on capital and reinvestment rates. Even if we overpaid and eventually had to sell in 20 years at half the Price to Book Value multiple we bought at, we would still outperform and achieve an annual investment return of 10-13%, representing a total payback of 6-12x our original investment.

2. Return on Invested Capital

Return on invested capital (ROIC) is a measure of the operating profits a business generates as a percentage of the capital required to run the business. The formula is given as:

ROIC = EBIT (1 - Tax) / (Debt + Equity - Excess Cash)

In comparing return on invested capital, Google consistently achieves market leading ROIC of above 38%, driven by its monopoly position in Search, arguably the most profitable business unit in the world today.

A return on capital of 38% means that for every $100 the business has invested - funded by debt, equity or retained profits - it generates $38 of after tax operating profits every year. Google has a reinvestment rate of 40%, meaning it is able to find attractive investment opportunities without diluting its high return of capital.

Amazon generates lower returns on capital of 16% as compared to Google, but reinvests over 100% of its profits for business growth across its cloud data centres, distribution warehouses, and retail inventory.

Costco generates a very high return on capital of 27% but has fewer opportunities to reinvest its profits. While Costco commands higher sales per store vs competitors, it expands slower and has kept growing cash on its balance sheet. While a growing cash balance is good, cash is a passive asset that does not actively contribute to business growth.

Finally, the mature business IBM has been unable to generate attractive returns on capital or find opportunities to reinvest its significant profits. Growth has been reliant on major disappointing acquisitions, such the $34bn acquisition of Red Hat.

3. Reinvestment Rate

A high return on capital is not enough to achieve compounding scale growth if the business is not able to find opportunities to reinvest in its profits.

The reinvestment rate can be measured as the growth in invested capital relative to the after tax operating profits generated that year. The formula is given as:

Reinvestment rate = Change in Invested Capital / EBIT (1-T)

Invested capital = Debt + Equity - Excess Cash

For Google and Amazon, despite their large size, they have been able to continually reinvest into their businesses while maintaining high returns on capital. Amazon continues to reinvest more aggressively than Google, given its higher capital requirements for retail and larger share of cloud computing.

4. EBIT Growth

Google has achieved impressive growth in operating profit, or EBIT, driven by its very high returns on capital and ability to continually invest profits also at high returns.

5. The rise and fall of Blackberry

Warning: In our investment example we assumed we could maintain returns on capital and reinvestment rates over the next 20 years. But most businesses will fail, and technology innovation is a highly destructive force.

The Nifty Fifty was a group of 50 large-cap stocks on the New York Stock Exchange during the 1960s and 70s, that traded often at double the P/E valuation of the index. Of the original Nifty Fifty, more than half have either ceased to exist or have significantly declined.

Blackberry maker RIM, as a more recent example, achieved spectacular growth, high returns on capital, and reinvestment rates. However, the success of the iPhone, Android and 4G mobile caused the rapid destruction of RIM.

This highlights the uncertainty and risk inherent in predicting long-term investment success. Capitalism is brutal.