IIf you want to outperform the market over the long term, buy stocks of growing companies that generate high and/or growing returns on invested capital (ROIC) at fair or better valuations.
|Compare ROIC||Company A||Company B|
|Desired EPS growth rate||
|Return on Invested Capital (ROIC)||20%||ten%|
|Reinvestment rate (solve using G = ROIC x Reinvestment)||25%||
|Remaining to be distributed (100% less reinvestment rate)||75%||50%|
|Free (or distributable) cash flow per $1 EPS||$0.75||$0.50|
As the first two charts above clearly show:
- Companies with a high return on investment outperform the market by a country mile and
- Companies with rising ROI outperform the market by a light year.
This is due to the fact ROIC is the most important financial measure. It is the ultimate measure of profit and performance and a primary driver of free movement of capital (FCF), which is ultimately what we are looking for as investors.
Here is a simple formula to show you how powerful ROIC really is. This formula is
ROIC x reinvestment rate = operating profit growth
Suppose we have two companies (Company A and Company B) that aim to grow their profits at a rate of 5% per year, but Company A has an ROIC of 20% and Company B has an ROIC of only 10 %. According to these parameters, Company A only needs to reinvest 25% of its profits to increase its profits by 5% (20% x 25% = 5%), but Company B needs to reinvest 50% of its profits to increase its profits. its profits at the same rate of 5%. rate (10% x 50% = 5%). See table above for calculations.
The company with the higher ROIC has a lower reinvestment rate and will need to reinvest less capital to achieve the same level of earnings growth. And because the higher ROIC business requires less capital (or reinvestment) to grow, it generates higher free cash flow (FCF), and free cash flow is what determines intrinsic value. Mathematically, companies with a higher return on investment generate more FCF per dollar of profit.
Let’s all say together: Companies with higher ROI generate more FCF per dollar of profit, and free cash flow growth is what drives intrinsic value growth!
Because these high ROI companies generate so much FCF, they can fund their growth internally rather than relying on outside capital (other people’s money) to grow. This means less debt or less equity dilution for shareholders. They can invest more in fortifying their moats. They can invest in new initiatives to build new moats and profitable growth streams over time. They can invest to care for stakeholders, including employees, customers, suppliers, communities and the planet. They can set their own deadlines, stay adaptable, and future-proof their business.
Finally, some of the excess FCF can be used to pay off existing debt, and what’s left will remain on the balance sheet to build even greater net cash (at least for many of our businesses), which further strengthens the ‘balance. build sheet and options.
Before we get to the formula, it’s important to point out that a company cannot grow its operating profit faster than its incremental ROIC without resorting to external financing. Basically, a company that generates a 20% ROIC cannot increase its operating profit by more than 20%, and to do so, it must reinvest 100% of its profits (20% x 100% = 20%). Remember this the next time you hear that such a company can sustainably increase profits by 40% or 50%. The answer is that it probably cannot do it without resorting to external funding.
An increase in ROIC still increases intrinsic value.
But an increase in income growth does not not always increase the intrinsic value. Growth only increases business value if a company’s return on investment is greater than its weighted average cost of capital (WACC).
If ROIC > WACC, growth increases intrinsic value.
If ROIC = WACC then growth neither creates nor destroys value.
This is why return on investment is more important than revenue growth…an increase in ROIC is always value added, but an increase in growth can actually destroy value, which is a major reasons why you see non-profit growth stocks blowing up. and drop by 50% to 70% or even more.
Now, if ROI is high, a one percentage point increase in revenue growth creates more value than a one percentage point increase in an already high ROI. So when ROIC is high, companies need to focus on growth and may even sacrifice some ROIC to drive growth (yes, a slight drop in ROIC can be a good thing). But when the return on investment is low, a company to have to focus on increasing its ROIC (to get it above WACC) before it goes into growth mode.
Don’t think about it too much. Understand the basics of growing intrinsic value! Focus on finding companies with strong balance sheets, high or increasing ROI and growing FCF, then don’t overpay.
In the end, FCF growth, what we pay for it, and the right mindset are about all that matters for long-term above-market returns.
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