Introduction
If you are a 90s kid like us, you could relate to an old Maruti car advertisement whose punchline was “Deti Kitna Hai” (which relates to the fuel efficiency of a car). As we Indians are more value seekers, Maruti wanted to drive home the idea of importance of fuel efficiency in making a car purchase decision.
The world of business and investing is like the punchline in this advertisement. The first question that an investor in any company should ask is how much it earns (modified version of saying “Kitna Deti Hai “) on the capital that a company has put in. The capital is the total money invested in the business and this includes both equity (owner’s money) and debt (lender’s money or borrowed money)
Return on invested capital (ROIC) is one such metric that helps investors evaluate how effectively a company is utilizing its capital to generate returns. However, ROIC only gives you the overall return a company is generating from its investments. To get a more accurate picture of a company’s investment strategy and future trajectory, investors also need to look at incremental ROIC i.e ROIIC.
Incremental ROIC tells investors how much value a company is creating from each additional dollar it invests in its business. By analyzing a company’s incremental ROIC, investors can evaluate whether the company is creating value for its shareholders and make informed investment decisions.
In this blog post, we’ll dive deeper into ROIC and incremental ROIC, and explain how they can help investors assess a company’s financial health and investment strategy. We’ll also provide some real-life examples to illustrate the concepts.
How to Calculate ROIC and ROIIC?
Return on invested capital (ROIC) is a financial metric that tells you how much profit a company is generating for every dollar it invests in its business. It helps investors evaluate how efficiently and profitably a company is using its resources to generate earnings. For instance, if a company invests INR 100 and generates INR 20 in earnings, its ROIC is 20% (20/100). Theoretically, one can calculate ROIC from the balance sheet as follows:
ROIC = Net Operating Profit After Taxes (NOPAT) / Invested Capital
where NOPAT = Operating Income *(1-tax rate)
Note: you can also calculate pre-tax ROIC to compare different companies.
Invested Capital is the total amount of capital invested in the business.
It can be calculated as:
Invested Capital = Total Equity + Total Debt – Cash and Cash Equivalents
Understanding ROIC and ROIIC
ROIC is a very useful metric to evaluate business efficiency. It tells us how much a company earns from its invested capital (“Kamati Kitna Hai”). If a company earns ROIC consistently above its cost of capital, then it creates value for its shareholders. This is also famously known as “Warren Buffet’s “One Dollar Test”.
Let’s understand this through an extremely simple example. A company invests INR1,000 in a new factory and estimates that the cost of its capital (which is weighted average of cost of its debt and equity) is 10%. If the factory generates INR 80 in after-tax earnings (or profit after tax) in perpetuity, the market value of the factory would be INR 800 (80/10%) and the investment would fail the Buffet’s one dollar test. On the other hand, if the same company earns INR 120 then it would create value of INR 1,200 (120/10%), hence passing the one-dollar test.
As companies announce investments such as acquisitions or capital expenditures, the market renders its judgment as to whether the investments add or detract from value. Remember the job of a CEO and CFO is to decide on where to put the resources of the company (i.e capital it generates for the business) which is in the best interest of the shareholders (owners of the company).
Notice that 10% is the discount rate assumed as this is the cost of capital. Hence, the core philosophy of value creation is that a company must earn more than its cost of capital. Hence, as a starting point investor must see a company’s past record of actual ROIC and compare it with its cost of capital
ROIC is also a key determinant of value creation.
Intrinsic value compounding rate = ROIC x Reinvestment rate
If a company reinvests 100% of its cash flows at 20% ROIC then its value will compound at 20% assuming all other things remain constant. In fact, the legendary investor Charlie Munger (Warren Buffet’s partner) mentioned that if you invest in a business that earns 18% return on capital over 20-30 years, you will end up with good results even if you pay an expensive looking price. Conversely, if you invest in a business with 6-8% ROIC, over the long term you will not earn more than this. Hence, an investor is better off investing in a company which consistently generates higher ROIC.
However, as an investor our objective is not to look only at historical ROIC and the spread between ROIC and cost of capital. We also need to evaluate the future ROIC trajectory (It’s like figuring out, “Aage Kitna Kamayegi”) as that will decide the investment return. This is where the concept of return on incremental invested capital (ROIIC) is extremely important.
The formula for ROIIC is simple:
ROIIC = (NOPATt – NOPATt-1)/ (Invested Capital(t-1) – Invested Capital (t-2))
Where NOPATt = Net Operating Profit after Tax in current year (say FY2023)
NOPAT(t-1) = Net Operating Profit after Tax in preceding year (FY2022)
Invested Capital(t-1) = Capital Invested in the business in Year (t-1) (FY2022)
Invested Capital(t-2) = Capital Invested in the business in Year (t-2) (FY2021)
If you look at it, we are calculating incremental capital invested in the business during FY2022 i.e (FY2022-FY2021) and how much Net Operating Profit after Tax company generated from this investment which is NOPAT in FY2023 less NOPAT in FY2022.
High ROIICs indicate that a business is either capital efficient or has substantial operating leverage.
These two ratios are extremely important when analyzing a company’s management and their capital allocation skills. Note that apart from capital expenditures (i.e reinvesting capital back in the business) capital allocation has other aspects as well such as buyback, dividends, mergers, and acquisitions. Hence, the analysis of ROIC and ROIIC helps in assessing management decisions on these aspects as well.
Also, note that unlike ROIC, one should not calculate ROIIC on a yearly basis as the figures will be quite volatile and erratic on a year-on-year basis. One should calculate it either on 3-year basis or 5- year basis as y-o-y results could be erratic.
One can get details about a company’s investment plan from its annual report, conference call and investor’s presentation. Analyze their investment plan to see how much return on capital this additional capex will generate and then make an investment thesis and track.
Applications
Let’s take some real like examples. Let’s take an example of one of the biggest wealth creators in Indian market and favourite stock of legendary investor Late. Mr. Rakesh Jhunjhunwala i.e “Titan”.
The table above shows Titan’s ROIC profile of last 10 years.
Titan has an impressive ROIC profile with ROIC more than 20% in each year except in FY21. Further, if you take an average of 3 Year Rolling ROIIC, it’s also well above 20% implying each additional capital reinvested in the business is generating 20% additional return. When management believes there are enough opportunities for the business to grow, they reinvest every penny into the business. This is what we as an investor and shareholders should look for. If there are no significant reinvestment opportunities, then management either distributes the capital in form of dividend or share buyback (like ITC) or uses the cash for inorganic expansion (acquisitions, common in IT companies). Between the two, the market rewards companies which are investing their capital back into business at a similar or higher rate of return on capital.
Now that we have conceptual understanding and with the benefit of hindsight, Let’s see why Titan turned out to be a big wealth creator.
The table below summarizes the NOPAT and ROIIC calculation for Titan during 2013-2022.
Let’s understand this table first. Refer to the formula for calculating ROIIC that we have mentioned earlier. By Investing INR 6,958 crores in the business during 2013-2021, Titan earned ~ INR 1,513 crores in NOPAT during 2014-22. This implies ROIIC for 22%. During 2013-21, cumulative NOPAT was INR 8,479 out of which INR 6,958 invested back in the business which is approximately 82% reinvestment of capital.
Refer to the formula mentioned above for intrinsic value compounding. We simply multiply the reinvestment rate with the return generated from the capital invested. In this case, reinvestment rate is ~82% while ROIC is 22% implying a theoretical value compounding of ~18%. The actual stock price CAGR in this period is ~28%. Obviously, stock prices will deviate and depend on starting valuation. The stock price movement is not what we are looking here at. The core idea is that if you have a business with high reinvestment opportunities at higher ROIIC. In that case, one should invest in such businesses and hold it for long term if ROIC trajectory is moving as expected and management is delivering on its capital allocation.
The other point is regarding valuation. We will cover this in another article, but just to give an idea, Titan was trading at PE multiple of 45 in 2013, not cheap by any means. Judging a company’s valuation solely based on PE can be a costly mistake.
Coming back to ROIC and ROIIC, one can get the details of investment plan from annual reports and investor call. For example, Kalyan Jewellers (Titan’s competition) is in the process of transforming their business model. Kalyan Jeweller historically has low ROIC (less than 10%) but as per new strategy, they are opening more franchise owned and company operated (FOCO) stores. They are also expanding in the non-south market which has higher operating margins. This asset light expansion strategy has higher return on capital (more than 20% as per management). Therefore, going forward the company is expected to generate higher cash flows (provided they execute their plan well).
One must investigate these details closely in the annual report and management discussion to uncover sound investment ideas rather than focussing on next quarter margin or next year revenue etc. In our experience, most people focus on value (using multiples etc) and price, but the core of investing (for long term) is to understand and figure out reinvestment opportunities. If you get it right, you will find your next titan.
Before we conclude, let’s have a look at similar working for ITC in the same period.
The table above is like the calculation we have presented for Titan. ITC’s intrinsic value compounding worked out to be only ~6%. No wonder stock price did nothing as market participants would normally prefer higher value compounding. Note that in this period, ITC’s PAT doubled.
Conclusion and Takeaways
To sum up, Historical high ROIC ca be a good starting point. However, we should focus more on the business which has higher reinvestment opportunities, and which invests most of its earnings back into the business. Such companies are like internal compounding machines, and one just needs to hold it for a long time. Given a choice, always prefer a company having higher ROIC. However, one must also assess the future ROIC trajectory from cthe company’s capital allocation policy and investment plan.
While our model portfolios are built on quantitative investment strategies, the foundation of these strategies are rooted in the principle explained above. We call it the ‘Quality Factor.’ Unlike many other quant strategies that focus on data for a one-year period, our approach delves deeper, utilizing a comprehensive 5-year historical analysis. We assign a higher weightage to companies that have demonstrated consistently higher Return on Invested Capital (ROIC). This ensures portfolio being allocated towards company with long-term performance and sustainability of its returns
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