Here’s a good problem for a company to have. You have more
demand for your products than you have inventory to satisfy it or current
capacity to build more inventory. You’re a profitable company, so you have net
income. What do you do with your earnings?
Easy. Produce more inventory, sell more product, and satisfy
the demand, right?
Perhaps, but this requires an investment of capital. Few
companies can resist the knee-jerk impulse to grow sales at every opportunity,
but growth often diminishes the value of a company.
When a company produces net income, its most basic decision
is whether to distribute that income to shareholders or reinvest it back into
the company. How should it go about making that choice?
The fundamental issue is whether plowing an additional
dollar of earnings back into building more inventory will produce more than a
dollar of incremental earnings. This is the ROIC question. If your analysis
suggests that the additional investment of earnings will produce $1.20 in
incremental earnings, your ROIC is 20% and probably higher than what your
shareholders could do with the money if you gave it back in the form of a
dividend. At any rate, it’s a fair return, and a CEO would be acting rationally
to retain those earnings for business growth.
If the company could produce the same 20% return by
reinvesting earnings year after year, shareholders would have a bona fide
compounding machine on their hands. Earnings would beget more earnings would
beget a higher value for the company.
Discarding short-term distortions and market moods that
affect stock price, a company is worth the earnings (or, more precisely, cash)
it will produce for investors from now till eternity. Indulge me…
If a company earns a stable $10 per share each year (and you
have complete confidence it will continue earning this same amount forever),
discounted cash flow theory tells us we value it like a bond. Using a 10%
discount rate and 0% growth rate, it is worth $100. (1/(0.10 - 0.0) = 10x current
earnings.)
If a company earns $10 per share and you can confidently
(and conservatively) say its earnings will increase 5% a year from now till
eternity, it is worth $200 using that same 10% discount rate. (1/(.10 – 0.05) =
20x current earnings.)
(Take careful note of the “if” condition used in both of the
discounted cash flow examples. No company can guarantee stable earnings
forever. Nor can you expect a company to grow its earnings at a set rate
forever. That’s not the nature of competitive markets in which companies
function. And trees never grow to the sky; everything has a maximum growth
capacity and peaks at some point. As a fair rule of thumb, the higher the
growth rate the earlier the peak.)
The point is a simple one: the ability to grow earnings is
clearly a very, very big deal in determining a company’s value. ROIC can be a
powerful metric for demonstrating whether the business is a compounding machine
that will grow earnings for owners and increase the value of their shares. That’s why I pay attention to it.
It is, however, worth making a couple notes of caution when
including ROIC in your kit of analytical tools:
Don’t use ROIC as a static measure…Test it over multiple periods.
The ROIC calculation consists of an earnings numerator and invested capital as denominator, both of which can
change from year to year for any given company. Some businesses will have
wildly fluctuating earnings, swinging from profits to losses and back to
profits again. Even if they maintain a low base of invested capital, a nice
ROIC today will lose all its luster tomorrow when the losses hit.
Here are two questions to use in tandem: For every increase
in invested capital, did the business show a larger increase in earnings? And
did this happen consistently over a multi-year period? Of course you capture
the gist of this exercise by simply calculating ROIC for each year and seeing
whether it stayed even, went up, or went down.
Businesses that are compounding machines will have earnings
that grow at a higher rate than their need for incremental invested capital
over multiple periods. (Though every company hits bumps in the road from time
to time.)
(This leads to an important aside question: what is enough
ROIC? I don’t think there’s a single good answer to that question. I once read
about Joel Greenblatt telling his business school students that they should
just say “good is good.” In other words, whether the business generates 20% or
70% ROIC, both are enough to indicate that the company can compound profits at
a satisfactory rate. I would only add that you want to see that a company’s
ROIC is equal to or better than competing companies in its industry that should
have similar capital requirements.)
ROIC is a quality measurement; it doesn’t tell you what a company is
worth.
Ah, a classic
investing conundrum…you find a company consistently producing 50% ROIC and
trading at 70x earnings. Do you invest in it? Most likely, no.
There are two guiding principles of long-term investing: 1.
Find a high quality company, and 2. Buy it for much less than what it’s worth.
ROIC only helps you with the first part of the equation, and a high-ROIC
producer can still be so overpriced that no conservative estimate of earnings
growth every lets it catch up to its trading price.
Alas, ROIC is no secret metric. You’ll find that most
high-ROIC producers have been discovered and are trading at a fair or high
price-to-value. But you’ll find two kinds of opportunities present themselves
from time to time.
One, a consistent high-ROIC producer is temporarily priced
cheap. The market thinks something is wrong with the company, has become bored
with it, or whatever. You have to determine whether you agree with the market’s
assessment. The market is often right, so I suggest you have compelling logic
for why it’s wrong before making an investment.
Two, a company is turning the corner on its business model
and either increasing earnings on the same invested capital base or decreasing
its capital base while producing the same earnings. Either way, ROIC increases.
You have to get out in front, normalizing these elements of the company’s
business and taking the risk that your assessment is right and will ultimately
be rewarded with a growing stock price.
Some expenses are not so different from invested capital.
Even if accounting standards keep them off the balance
sheet, there are several categories of expense that can serve the same purpose
as assets. In other words, investments in them are necessary to maintain or
grow the business. Examples include: long-term (but uncapitalized) leases,
research and development, expensed technology projects, and marketing expenses.
The important point is that a failure to put money into
these expenses would directly affect the company’s ability to sell its products
or services. For example, Paychex (PAYX) generates an eye-popping ROIC.
Its need for capital is minimal compared to its ability to generate impressive
earnings. But Paychex operates in a brutally competitive market for small
business payroll and HR services where keeping market share is dependent upon expanding
its army of salespeople on the street. Make no mistake, sales and marketing
expenses are a required investment for the company, akin to sinking working
capital into inventory. If it stopped hiring, its sales would drop quickly. Yet
sales and marketing will always be categorized as an expense, allowing Paychex
to show a higher ROIC and suggesting it needs less investment to maintain its
business than it actually does.
It's critical to identify which expenses must expand in order for the business to grow revenue. The savvy investor will treat those expenses much like he would invested capital...checking to make sure he's getting at least $1 back in earnings for every dollar the company plows into these expenses.
