To boldly go, beyond ROIC: what to do?

It's not the holy grail

Return on investment (ROI). It’s a common measure used to evaluate any investment opportunity.

You have to choose which ROI you want to use.

• The Return is the nominator

• The Investment is the denominator.

ROIC is not the holy grail though.

I’ve read a lot of investing books this year. Every book on quality investing sets a minimum ROIC threshold.

The basic idea is:

• ROIC should be as high as possible

• At least, it needs to be higher than the cost of capital

But there’s a problem.

ROIC is accounting-based. The cost of capital is also an estimate. You’re comparing one estimate against the other. Does that make any sense?

And then a year ago, I came across the GOAT:

I know. The man has the best profile picture ever. But his bio is the gold we are digging for.

If you haven’t heard of Jason, he started with a small portfolio and became a full-time microcap investor managing a nine-figure portfolio. (yep, it’s not a spelling error, it’s a niner).

Let’s first dissect ROIC and identify the problems. Then, we’ll examine what we can do better and return to Jason’s statement.

The vivisection of ROIC

Let’s get through the formulas first. The most widespread definition is as follows:

ROIC = NOPAT / INVESTED CAPITAL

NOPAT is the net operating profit after tax

NOPAT = EBIT (1-TAX RATE)

Invested Capital is the money that is invested, so the capital is raised from either debt or equity to cover the working capital requirements and acquire Plant people and equipment or other investments.

INVESTED CAPITAL can be calculated using an operating or financial approach. Either way, it's the capital invested over time. From a financial view, you add together equity and debt. From an operating perspective, you add together:

• Net Working Capital

• Net PP&E

• And if an acquisition was made you could include intangibles and goodwill

Now let’s take Dino Polska (A Polish retailer) as an example. Instead of NOPAT, we’ll use net income to make it easier.

Dino Polska: Where is it headed? A destination analysis

But before showing the resulting table, ROIC itself does not have a lot of use. We need to pair it with the reinvestment rate. How much of those precious earnings can the company reinvest every year? The combination of both gives us the growth rate.

In addition to reinvestment, returns can be improved through buybacks and dividends. I’ve added them to the overview below, but Dino has none, so the value is 0.

Author calculation of ROIC and RIR

We compared 2023 to the first reporting year for Dino in 2014. The results?

• A solid ROIC of 22.8%

• An incredible reinvestment rate of 112%

• The product of both is an intrinsic value compounding rate

This is compounding at its finest, pure and simple. We only have the stock price available since 2018, but if we add 4 years to the CAGR equation, we arrive more or less at a 22% CAGR.

There are very few companies in the world that display these kinds of characteristics. ROIC is a great metric. But it’s not the holy grail. Let’s look at some problems:

Problem n°1: ROIC is backward-looking

By definition, you’re taking into account the entire invested capital base since the company started. So if a company generates 100 million, and its invested capital up until now is 200 million, then you’ve got a 50% ROIC.

Will the future be similar to the past?

Hard to say.

• What is the company’s competitive position?

• Is it getting stronger or weaker?

• How will margins evolve?

An example: Disney

Here’s a picture of Disney’s ROIC until 2018:

Guess what happened next?

Now you could argue that nobody could have predicted the pandemic. But 2019 was already a down year. And since 2020, Disney has been struggling to recover.

What about Dino?

Over the past 10 years, Dino’s store count grew from 400 to 2400. (6X) In the coming decade, Dino’s stores will double, maybe triple, but not more.

Dino will not be able to maintain a 100% reinvestment rate. More and more cash will be available and we’ll have to wait and see if Dino will boost shareholder returns by providing a dividend or a buyback program.

Dino and its competitors have profited from a fragmented market. They have been gobbling up all the mom-and-pop stores. There is still room to use the same strategy but over the coming years, saturation will happen which might lead to even greater competition between the top players.

In other words, based on past ROIC and Reinvestment rates, do not expect a 25% CAGR in the coming decade!

Problem n°2: No uniform method of calculation

Let’s once more use an example: Medpace (Ticker: MEDP) Medpace is a company that services pharmaceuticals and biotech companies. It helps them with their clinical trials.

We’re going to take a look at 3rd party software providers and see what kind of ROIC they are touting.

Here’s the ROIC for 2023:

• 17.6% according to finchat.io

• 16.7% according to gurufocus.com

• 25.0% according to alphaspread.com

Finchat and guru focus are quite similar. But then alpha spread differs. What now?

Always do your own ROIC calculation so you know what is going on. An ROIC is context-specific. Without contextualizing it, it’s pretty useless.

Problem n°3: The ROIC value is not enough, trend and compare

Imagine you have a company with a high ROIC. Great. Now what?

What matters more are 2 things:

First, the trend of ROIC is more important than the absolute value

One of the most obvious examples in the market:

This is what you want. You want a ROIC profile that looks like a jet taking off from the tarmac. (and ideally, you’ve boarded the jet at the start of the runway 😉)

• The price of MEDP at the end of 2016? 35

• The price of MEDP now = 340

• A 10-bagger

When the ROIC increases, the company can use its means more and more efficiently. It will generate EPS growth. When the market sees that ROIC becomes attractive, it will assign an increased multiple, so now you get a multiple expansion on top of EPS growth.

Medpace is special. It had a trailing P/E of 97 at the end of 2016 (quickly after its IPO). Since then, it has never traded below a P/E of 23 with a current P/E of 29. But just as ROIC is not the holy grail, we’ve discussed the dangers of the P/E ratio in the past:

Stop using the P/E multiple

Second, always compare the ROIC of your company to its competitors.

Imagine you’re running a marathon. You’re running inside a pack and see the leader in the distance. Every additional mile, you see the leader runner farther and farther away, until he disappears on the horizon.

It’s the same if your company has a consistently higher ROIC than the others. It needs less outside funding and is more efficient than all the others. It’s running away from the pack.

Back to Poland. Biedronka is the market leader in retail Poland, and it’s a pretty good company. But one runner is more efficient:

So always compare the ROIC of the companies within an industry.

The future

Now let’s get back to Jason Hirshman.

“Seeking undiscovered future high ROIC companies”

The premise is simple. If they are undiscovered, they are probably cheap. If they increase ROIC over time, their quality increases.

This means Multiple Expansion and EPS growth = The double whammy

The only thing missing in this statement is a high reinvestment rate (complemented with dividends or buybacks).

We’ll end this discussion with Buffett:

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”

– Warren Buffett, 1992 Shareholder Letter

Find companies that can earn a high return on incremental investments in the future. It’s not about the capital that was spent in the past. How much can they earn on additional capital investments?

To get an idea of how efficient the company has been recently, you can use ROIIC.

Let’s get back to Dino Polska and look at the numbers from 2022 and 2023

The formula is as follows:

ROIIC = (Profit (2023) - Profit (2022)) / (IC (2023) - (IC(2022))

with IC = Invested Capital

And the result:

Author calculation

ROIIC can be swingy. To get a smoother trend, you can use 3-year rolling periods. It still doesn’t provide you with an estimate of the future. But it gives you an idea if the company is getting more or less efficient.

Summary

• ROIC is a great indicator, but it is backward-looking

• The trend is as important as the absolute value

• The relative value to competitors is what matters

• Use ROIIC to get an idea of the incremental efficiency

• You’ll need to forecast the future: a solid understanding of the potential market and competitive positioning is needed. Past ROIC can inform you, but it is not enough

May the markets be with you, always!

Kevin