#25 Compounding Value: Part II
The holy grail of long-term investing: ROIIC & reinvestment rate
Last week we saw some common pitfalls around the return on invested capital and the importance of quality growth. Today we are analyzing two additional tools that allow us to understand in depth how companies generate value in incremental periods of time: the return on incremental invested capital and the reinvestment rate.
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The return on invested capital ROIC tells us the rate of return the company is generating on capital that has already been invested. If we think about it, these investments could have been done many years ago and still could be generating returns. We can agree that a company with high returns on capital is a good business. But how do we understand the evolution in the most recent years? It is a key analysis if we want to predict reasonably what can be expected in the future, and how much money the company can generate going forward on future capital investments.
Return on Incremental Invested Capital (ROIIC)
Return on capital measures how efficiently a company has made use of all its capital to generate profit in a particular year. If I have 100m of capital in use to get 20m profit, my return on capital was 20%.
Now, the return on incremental capital investments is the amount of capital the business has added over a period of time, and compared to the amount of the incremental growth of earnings. Following the previous analogy, imagine the next year we invest these 20m of profit back in the business. Our invested capital now would be 120m. If the next year we achieve 30m in profit, our new ROIC would be 25%. However, the incremental profit on these extra 20m of capital would be 10m, meaning a 50% return on incremental invested capital.
The return on incremental invested capital gives us an idea of whether the business is actually improving its quality or whether it is expanding into areas that are not as good as the “original” business, but still better than usual. But it also gives us advanced information if the business is deteriorating.
Keep in mind that it is not always so simple to get a qualitative assessment on this metric. Profits may have increased not because of the additional capital invested, but because of price increases, or many other reasons. The important thing is to be aware of it and think of the reasons why these two variables change along the life of the business.
A beautiful paradox
Not all growth creates value, and not all ROIICs below ROIC destroy value.
It is completely counterintuitive. Let's try to break it down and check the math. We come back to our simple examples. Consider a company that has 100m of capital invested with a return on capital of 30% (such great companies we have here as examples). As always, we assume our opportunity cost to be 15%. Under these conditions, in year 1, the company will have generated an additional 15m of value over our opportunity cost.
Imagine that on that initial invested capital, the company’s return for the next 3 years is going to be the same. We neglect any potential depreciation and maintenance CAPEX, but we also leave aside possible price increases. In short, we assume that those 100m will generate 30m of operating profit for the next 3 years. Now, in addition, the company decides to invest new capital at different returns on incremental capital.
Outcomes from the previous table:
- When a company with a high ROIC reinvests capital at very low ROIICs, the company still creates value for shareholders, even if this is lower than if it wouldn’t have added new capital.
- For a company with a high ROIC, the way to create additional value is with ROIICs higher than our opportunity cost (cost of capital), but not necessarily at higher returns than before.
- Companies with a high ROIC should reinvest in the business as much as possible to maximize value creation, until additional expected returns come at rates lower than the cost of capital (for investors the opportunity cost).
Reinvestment Rate
We all love growth, but new revenue doesn’t fall into our hands magically. It is normally a consequence of new investments (growth CAPEX, R&D, etc).
The formula below expresses the ratio at which the company invests the profits back into the business. It is the difference between the invested capital over two periods (being puristic we should add back the amortizations and impairments that happened during this period), divided by the cumulative profits of the company during this time:
But the reinvestment rate doesn’t give us any value by itself. It is the combination of the reinvestment rate and the ROIIC where the magic begins.
Compounding value
A company will see its intrinsic value compound at a rate that roughly equals the product of its ROIIC and its reinvestment rate:
Intrinsic Value Compounding Rate = ROIIC x Reinvestment Rate
We are leaving aside other important aspects which can make a company create value on top of it:
- Capital allocation, the way management allocates the profits not reinvested in the business (acquisitions, buybacks, dividends, or paying debt) can increase or decrease value per share as well.
- Multiple expansion/contraction, which can happen if a company improves/deteriorates its competitive situation, or by expansive/contractive monetary policies of the central banks.
To see how the intrinsic value creation formula is actually quite reliable, let’s take a look at Costco and Walmart during the decade between 2010 and 2020.
We can look at the last 10 years and see that Costco and Walmart have reinvested roughly 58% and 26% of their earnings back into the business. However, the results have been quite different. While Costco has reinvested its profits at 18% ROIIC, Walmart has done it at a -3%.
So if Costco retained 58% of its capital and reinvested that capital at an 18% return, we could have expected the value of the company to have grown at a rate of around 10% per year. On the other side, we could have expected Walmart to decrease its value by 1% a year.
But that is not all. Stockholders will likely see higher per-share returns than that because of dividends and buyback, especially in the case of Walmart, since it was reinvesting less in the business.
Furthermore, and surprisingly, both companies had the same multiple expansion in these 10 years. Both companies doubled their multiples.
And lastly, we have to consider also the price of the shares in 2010 could be undervalued/overvalued, and the same could have happened in 2020.
Overall, and considering all we have said, we can see that Costco's stock price has compounded at 17% annually, very much in line with our Costco’s intrinsic value compounding, plus an x2 from the multiple expansion. Similarly, our expectation for Walmart’s stock price, given their performance and doubling the multiple (again, surprisingly and a clear consequence of the monetary expansion), would have made it be valued at $98 in 2020, not far away from the actual 120.
Not all is plain sailing
A final note of caution. We have to be aware this framework is not always applicable. ROIC simply isn't that relevant of a concept for capital-light businesses. As we have seen, return on invested capital is a useful model when your growth depends on putting more capital into the game.
But when a business does not use capital to grow (e.g., price increases, new franchise licenses, etc.), the ROIC approach just isn't that relevant. The classic example: if the fund you work at bought new office space and equipment with retained profits, doubling the book equity invested in the fund, would you expect its profits to double as well? Investing, analyzing businesses, is about common sense. Understand how businesses create value and monitor them closely to understand the dynamics. What we have seen might be useful many times, but it is not an infallible tool. Always think by yourself. Use our brain.
The next and last post on this series will bring more qualitative assessments so we can see how companies evolve over time and how their stock prices follow their business fundamentals, even if sometimes, as we have seen with Walmart, we are also at the expense of our beloved monetary authorities.
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References
Ahern, D. (2021) Investor’s Guide to Incremental Invested Capital (ROIIC). EIB. Link
Bezos, J. (2004). Letter to shareholders. Amazon.com Link
Huber, J. (2016a). Calculating the Return on Incremental Capital Investments. Saber Capital Management. Link
Huber, J. (2016b). Importance of ROIC: “Reinvestment” vs “Legacy” Moats. Saber Capital Management.Link
Koller, T., Goedhart, M., Wessels, D.(2020) Valuation: Measuring and Managing the Value of Companies. Wiley. 7th edition
Mauboussin, M.J., Callahan, D. (2014) Calculating Return on Invested Capital: How to Determine ROIC and Address Common Issues. Credit Suisse. Link
Leonard, M. (2010). Letter to shareholders 2009. Constellation Software.
Lui. F (2017). Calculating Incremental ROIC’s. Hayden Capital. Link
Stannard-Stockton, S. (2016) Return on invested capital: why it matters & how we calculate it. Ensemble Capital. Link
Excellent 2. Part. Keep it up the good work, thanks!
Excellent topic 💪🏻 thanks