“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
(See my other posts discussing the man for more Buffet investment advice and ROIC wisdom.)
ROIC is a way of estimating how much a company gets back in income (the return) for every dollar of operating assets it deploys (the investment) in the enterprise. Operating assets are anything used by the business to make money – accounts receivable, PP&E, operating cash, etc. ROIC is the ratio of return to this investment.
We examine this ratio historically, with the hope that it may inform how productively the company deploys capital in the future. We are very interested in future capital productivity because it will dictate earnings and growth of earnings. Of course, we want the highest returns possible and we want to get the most we can out of every dollar the business commits to growth via investment, for as long as possible.
This is a subject near to our hearts as investors because the present value of those future streams of income net of incremental investments each year dictates today’s intrinsic value of the business. If valuation matters to you as an investor (and it certainly doesn’t for everyone) you want to have this information because you want to feel that you own the stock at some discount to this intrinsic value – that’s where market-beating returns come from.
As a side note, while Margin of Maybe is quite distinct from other stock analysis websites in its approach, it’s mostly about stock-picking and trying to do it well, so I have answered the What Is It and Why Do We Care questions from that perspective. But the other main use for ROIC analysis is to evaluate (and compensate) managers of businesses: how well do they deploy the assets of the enterprise and allocate capital in general in serving shareholders? How does this compare to their industry peers or the goals the board had previously laid out? Executive comp is often linked to ROIC metrics and of course, it is often successfully gamed by C-suite executives. This is beyond the scope of these posts, but here is an OK article on that topic.
When thinking about ROIC, I think it’s important to establish at the outset that the concept exists at the intersection of at least four different areas or disciplines which one has to have some understanding of to really “get” ROIC and use it effectively:
- Accounting – We use the balance sheet and income statement as a starting point and then do some thinking about the capital invested in the business and how much has been earned on that capital in the past. Why? Why not – if the financials have been audited, they are probably reliable, and there is a lot of useful info there and it’s easily accessible. So we use it. Yes it’s accrual-based and there is some arbitrary treatment of items relevant for ROIC analysis but it’s a great starting point.
- Finance – The rate of return that we get via a ratio that comes from financial statements is essentially a financial concept: is it high? Is it low? How does it compare to rates of return of company peers or the risk-free rate plus some premium? Is it above the company’s cost of capital? These are finance concepts through and through.
- Economics – The presence of economic profits (i.e., ROIC – Cost of Capital = Economic Profit) or Economic Goodwill suggests some kind of competitive advantage or moat around the business. The higher the economic profit, the wider the moat. What exactly are the sources of those advantages and how sustainable are they? This is an economic analysis.
- Strategy – How should the business be orienting the products or services it offers or is developing, and how does it deploy assets (including acquisitions) to generate profitable growth? In other words, effective boards and management teams use ROIC to guide their strategic initiatives and capital allocation.
Joel Greenblatt’s The Little Book That Beats The Market provides a very simple take on ROIC which touches on most of these areas (without saying so) and I’d be remiss for failing to mention it in a simplified introduction to ROIC. In the context of his two-part Magic Formula for picking stocks (1. good businesses, 2. attractive valuations) he uses return on capital as the metric for the “good business” part and a running story about a kid’s business selling gum to illustrate it.
The story begins on page 2 of the book, but essentially, he tells the reader about the basic economics of gum selling and making and shows in very simple terms that the income from the gum is a pretty desirable return on what it costs to make and distribute the gum. If it can be repeated over and over i.e., build new gum factories to support more and more gum sales at the same or better prices and rate of return (big assumptions…), that would be a good business to own, all other things equal. The idea is, that’s the same general way to apply ROIC in thinking about public equities one would likely want to own, which is part 1 of the formula. Own the good businesses that can generate high returns on investment and reinvest those returns indefinitely, like the gum business.
Here is a link to notes from a lecture Joel Greenblatt gave at Columbia Business School in 2005 – I found it on the Internet. The gum story is touched on here, and from what I can tell there are 67 references to “ROIC” in the notes – not to mention a ton of other great stuff that I will likely go back to elsewhere on this blog in the future. It’s definitely worth reading – a few times.
In the next post, I will get into some of the details of the ROIC calculation
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