Understanding Return on Invested Capital
All businesses are subject to the same laws of economics, finance and rules of accounting. Leaving economic components aside for a moment, return on invested capital is the mechanism for decision making within a business.
Stated another way, accounting is the language of business but finance and return on capital outlays are the mechanism for understanding comparable investments in or outside of a business. The laws of finance determine if a manager or owner should use the capital of a firm to invest in growth, distribute earnings to shareholders or liquidate the assets. In a shareholder orientation, managers, hired to represent owner interests, have the responsibility to maximize value for shareholders.
Measuring return on invested capital should be a core consideration in use of all business expenses or capital outlays. What follows is how we arrive at that conclusion.
Imagine for a moment that every business in existence can be reduced to three simple components, inputs and outputs and a net effect. Some amount of money goes into the production of a good or service so that consumption of what was produced or made available can then occur. What is left is a net effect.
Now let’s use business terms. Expenses are production, revenues are consumption. Net effects can be positive or negative in the form of profits and losses. In loss making scenarios the economic effect is that the business and its owners become the consumers of what was produced.
Positive outcomes however, are where the fun starts. Managers have access to more money than when they started. Real returns are characterized as putting in one dollar of investment and receiving more than one dollar in return in very short order. That excess capital in the form earnings can then be used to attempt to grow earnings or be paid to owners.
The perfect business would require no additional capital investment and could steadily grow revenues and earnings without growing expenses. Expenses would never go up, but revenues and profits would continually rise.
The best we can hope for in reality however is a company that has a high return on invested capital, doesn’t need a consistent amount of additional capital investment and has pricing power.
Return on capital is the measure of how efficiently the firm uses the money left over to produce additional profits in future years. Putting in additional one dollar bills and hopefully getting more back than were put in. If the company can increase profitability without spending much more to produce or market and sell its product or taking on considerable debt to grow, the natural results will be a higher return on invested capital than a firm that requires the opposite.
Economic characteristics difference have been well enough defined by others and don’t need to be repeated here. Broadly, companies can be placed into three categories of return on invested capital. The structure of how a business’s economic characteristics differ are, in effect, their different ROIC profiles.
Refer to this concise 2016 article by John Hubert of Saber Capital Management. His summation is spot on.
The complicating factor in in measuring ROIC is that the component parts that make up a business can sometimes not be immediately measurable. Minute aspects of marketing certainly follow this rule. And, businesses do not grow in absolute linear paths let alone produce a consistent and steady profit every year for eternity.
Take for instance that forty percent of all publicly listed companies did not turn a profit om 2019. Among the smallest eighty percent of those companies there has been a long-term increase in persistent loss makers—those losing money for three years.
More than enough market data on public companies exists to show that profitability, revenue, operating margin can vary dramatically for a business over an extended period and especially as it reaches a new phase in its business cycle. Many companies in 2020 are in a new phase of the business cycle right now. Retail and distributors are actively being disrupted by the internet.
Importantly, some businesses will never grow beyond a certain size or level of profitability due to a cocktail of reasons that may never be relatively defined. In these situations, management more often destroys shareholder value rather than creating it. Most management teams fall into patterned mentalities of a growth at all costs rather than a growth at opportunity cost mentality. In unfortunate cases, it comes at the expense of shareholders and the financial benefit of management.
Many firms will plateau, even reach the top of their market. Management may have even pursued growth at all costs to get there, not accepting these facts, likely not recognizing they are subject to them. Meanwhile, shareholder value has been slashed at the expense of owners.
It is unreasonable and silly to assume that any investor, or anyone on the planet has foreknowledge about the future distributable cashflows of a business in an absolute sense. As such, investors can never hold managers fully accountable for what they cannot control in the absolute. Skill certainly plays a role, as does the opportunity expand opportunity cost for the firm and to invest wisely and reduce risk.
Performance consistency of a business, even at reduced near term earnings is a valid use of the firm’s capital, as consistent performance will generally always trump unrepeatable processes which may individually have deleterious effects.
Investors and managers must therefore consider if the business will facilitate a favorable return on incremental invested capital internally or elsewhere.
For owner operators of businesses bumping up against such plateaus where low return on additional invested capital is the case is the norm, it would be perhaps best to structure the business to run without them.
After reducing risk to cashflows and hiring managers who can understand this fact and run the business for them will likely be a better use of their talents and time. Besides, if they understand how to measure return on invested capital, a consistent distribution of excess profits from their business interest will most certainly lead to opportunities elsewhere well beyond their tenure.
An investments’ valuation should be dependent on that investment’s internal use of capital and ability to compound capital for long periods of time. To summarize the importance of the change we can lean on the words of others.
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 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much difference than 6% return – even if you originally buy at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.
-Charlie Munger
What evidence is there to support this concept as being so important that it should be worked into the framework of every management decision? For that, I will leave the journalism to the journalists and point you to some great resources:
Forbes:
Morningstar:
http://news.morningstar.com/classroom2/course.asp?docId=145095&page=9
Mckinsey & Company:
https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/a-long-term-look-at-roic
NYU Stern:
http://people.stern.nyu.edu/adamodar/pdfiles/papers/returnmeasures.pdf
SBH ALL CAP Equity Research Publication
https://www.sbhic.com/wp-content/uploads/2015/11/SBH-Return-on-Invested-Capital.pdf