How Return on Invested Capital and Growth Creates Value

Short-termism runs deep when managers plan, execute, and report their performance in earnings per share (EPS). For example, when a company acquires a target, managers and investors often focus on whether the transaction will dilute EPS over the first year or two.

This is despite research demonstrating that increased EPS does not prove value creation. In other words, deals that increase EPS and deals that reduce EPS are equally likely to create or destroy value.

Note: Buffett’s 1984 letter is helpful in understanding the concept of value creation.

So what drives value?

Value is driven by three things: growth, return on invested capital (ROIC), and the cost of capital (COC).

Not all growth is equal.

Value creation happens when ROIC > COC and a company invests for growth.

Value is destroyed when ROIC < COC and a company invests for growth.

Value doesn’t change when ROIC = COC. In such cases, it doesn’t matter if the company invests for growth.

High ROIC companies create value by focusing on growth (i.e. expanding), while lower ROIC companies create more value by increasing ROIC (i.e. downsizing).

Here comes the formula for ROIC: after-tax operating profits divided by the capital invested in working capital and property, plant, and equipment (PPE).

Note that Joel Greenblatt applies the formula slightly differently: before-tax operating profits divided by the capital invested in working capital and property, plant, and equipment (PPE).

This method is helpful for comparing earnings power across different time periods, without being affected by varying tax rates.

Operating Profits

Operating profits is also known as earnings before interests and taxes (EBIT).

It is a ‘cleaner’ figure to measure the true earnings power of a company when compared to net income. It includes all expenses needed to keep the business running.

Going below operating income, we can see items such as interest revenue/expenses and extraordinary items. For example, sales of business assets would come below the operating income.

This income from selling business assets is not conducted in the normal operations of a business and does not reflect the ‘true earning power’ of a business.

You may refer to my earlier post (Finding the Next Multi-Bagger by Understanding Operating Expenses) for deeper understanding.

Invested Capital

Invested capital represents what the business has invested to run its operations—largely PPE and working capital.

Let’s use Costco as an example for this.

To open a new store, Costco will have to buy shelves, cashiers, and perhaps land to build its store. This would constitute its PPE investments.

Working capital is the money that a business needs to operate its business.

Generally, having a new store would require the business to lock-in additional money to stock up inventory.

If it offers credit terms (i.e. allows customers to pay in installments), more working capital is required. This is because they would be required to pay suppliers first while waiting for customers to pay them or they would be waiting for the inventory sitting on the shelves to be sold.

Oh, but Costco is rather different.

In fact, they are quite the opposite.

Before its customers start shopping, they collect a membership fee. Their customers are effectively financing their growth by injecting cash into Costco even before they start buying its goods.

Because of their size, they are able to negotiate favorable terms by paying suppliers approximately 1 month after they get the inventory. On the other hand, customers have to pay immediately when they purchase from Costco.

This means that Costco’s suppliers are also financing their growth when they’re able to delay payment to their suppliers.

Their inventory turnover—how fast they clear their shelves—is also one of the best in the industry.

Capital doesn’t stay locked up in Costco for very long.

And when cash isn’t locked up in a business, it can be distributed to shareholders, used to buy back shares, or be reinvested for growth!

Working capital needs or the lack thereof is one of the most overlooked metrics amongst others.

Starbucks in recent years is also showing early indications that it will benefit from working capital improvements, with its membership (prepaid cards) gaining wide popularity.

Coffee addicts lovers are effectively financing Starbucks’ growth by putting in cash before they make their purchase.

If you think Apple Pay, Google Pay, and Samsung Pay is popular, wait till you see ‘Starbucks pay’.

Conclusion

In conclusion, ROIC measures the earning power of a business. The lesser capital it requires to generate that additional amount of revenue, the more money is leftover to be distributed to shareholders.

High ROIC combined with growth and a strong moat will compound your capital nicely for years to come when you pay a fair price.

You read my earlier posts on this topic:

• Figuring out a company’s intrinsic value with PE ratio
• How to filter for high-quality compounders
• What makes Mastercard a compounding machine
• Facebook’s incredible business model – Part 2

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