Return on Invested Capital: Part Two – Better Use of Capital = Competitive Advantage

As we saw in the previous installment, a company that can plow its earnings back into the business and continue generating  a high rate of return (as measured by ROIC) is a compounding machine. It will grow its earnings and enrich any shareholder that bought stock at a reasonable price.

This time around, let’s look at a theoretical comparison of two businesses that make the same earnings but with dramatically different invested capital requirements.

Company A is a retailer that needs $165 million of invested capital to generate $15 million in earnings, about 9% ROIC. Most of the capital goes toward inventory with the remainder spread among warehouse space, capitalized technology projects, and equipment.

Company B is a retailer that needs $30 million of invested capital to generate $15 million in earnings, a 50% ROIC.

Assuming a steady ROIC rate, how much does each company need to invest in its business to grow earnings 25% next year?

Let’s start with Company B. At 50% ROIC it must invest $7.5 million of its $15 million earnings to generate a $3.75 million (or 25%) increase in earnings.

COMPANY B	Year One	Reinvested Capital	Year Two	Incremental Earnings
Invested Capital	$30M	+$7.5M (25%)	$37.5M
Earnings	$15M		$18.75M	+$3.75M (25%)
ROIC	50%		50%

For Company A, at 9% ROIC it must invest $40 million over the previous year to generate $3.75 million (25%) in increased earnings.

COMPANY A	Year One	Reinvested Capital	Year Two	Incremental Earnings
Invested Capital	$165M	+$40M (24%)	$205M
Earnings	$15M		$18.75M	+$3.75M (25%)
ROIC	9%		9%

Wow, right? Company B only had to reinvest half of its earning, and it produced a nice bump to incremental earnings. What are its options with the remaining $7.5 million? It can distribute it to shareholders, making them quite pleased. It can reduce its prices to deter competitors from entering its market. It can reinvest that money in marketing or research to create competitive advantages. Or, if possible, it could just reinvest the rest as capital and keep compounding those earnings.

Poor Company A. I hope it has access to debt markets for funding, or that its shareholders are willing to take a dilution as it goes out to raise cash. It certainly can’t cover that $40 million need for additional capital with earnings. Moreover, it’s probably losing ground to more efficiently capitalized competitors that can afford to fund branding initiatives or improve the look of their websites or however else they might use their extra cash.

Surely this is a mythical example, right? It’s meant to create an absurd contrast, right? Company A would be long dead in the real Darwinian world of capitalism, right?

Well, Company A’s invested capital is the same as Overstock.com in a particularly bad state at the end of 2005 (when it also had a $25 million loss). And Company B is…pretty close to Overstock.com at the end of 2010 after redesigning its business model. The reinvestment scenarios are hypotheticals, but I think it makes the point.

Allow me highlight that the stock was trading north of $34/share when the company announced end of year 2005 results. Today it trades around $14/share though, in terms of invested capital needs at least, it’s a much different company.

Next we’ll discuss the dog-eat-dog world of business and why a high-ROIC business must have some sustainable advantage to keep the bigger dogs at bay.