ROIC. Why Do We Care?

There’s a lot out there on return on invested capital (ROIC): different acronyms and terminology, approaches to calculating and adjusting the basic ratio, viewpoints on what a good/bad return on capital is, and even what is to be gained from the exercise in the first place.  

This has created a certain amount of confusion and some misconceptions on the topic.  I have suffered from this confusion myself over the years, and struggled to find fast and clear answers to my questions. I hope these blog posts will make this easier for others. 

I have also spent most of the last 20+ years making good on my vow to never use Buffett/Munger quotes, but the fact is that this quote from Munger is the single best answer to the Why Do We Care question, so I surrender to it:

“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.”

It’s true.  Success or failure in generating strong returns via individual stocks for fundamental, buy-and-hold investors almost always comes back to the capital productivity of the underlying business and its reinvestment opportunities over a span of years in the future.  Do you want to own a $1 bill for 60 cents that remains $1 forever, or own a $1 bill that makes 25 cents next year and more than that each year thereafter, and pay 80 cents for that $1, or maybe even $10?  The latter scenario is where ROIC becomes very, very relevant.  If you are going to own a stock for a while, you simply must have a view on how successfully it will deploy capital, which involves looking at how successful it has been doing that in the past, i.e., ROIC. 

As such, my goal for this series of posts is to strike a good balance between providing clarity of top-level thought and detailed direction on how to actually apply ROIC analysis on a day-to-day basis as part of the security selection research process. 

Some of the things I will cover:

I look forward to your feedback and I hope we can all learn from this blog.  In the next post I’ll get into more detail on ROIC

Please email me with questions/comments/errors related to this post!