Wednesday, May 18, 2011

Return on Invested Capital: Part One – Compounding Machines (With Appreciating Values)

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.

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