ROIC: The Building Block For a Efficient Business!
In my early days of investing, I scrutinized every business metric. Over time, I've streamlined my focus to a select few. Today, let's delve into one that holds a special place in my heart: ROIC.
The importance of investing with a solid return
Return-on-capital metrics gauge the effectiveness of a company's capital allocation decisions and serve as arguably the best shorthand expression of its industrial positioning and competitive advantages. Theoretically, returns on capital should equal the opportunity cost of capital. However, industries or companies generating economic profit typically attract competition, and competitive pressure gradually erodes profitability, erasing economic profit. Consequently, in perfectly competitive markets, companies earn no economic profit. Achieving sustained high returns on capital requires possessing features that shield returns from competition, namely, competitive advantages. Identifying these competitive advantages and understanding their sustainability is an essential aspect of the quality investment process.
Quality investing centers on a company's capacity to invest capital at high rates of return: post-tax levels of high-teen (and higher) are feasible. Three elements drive corporate cash returns on investments: Asset turnover measures how efficiently a company generates sales for additional assets, which can vary greatly depending on the asset intensity of the industry itself; margins reflect the benefit of those incremental sales; and cash conversion reflects the company's working capital intensity and the conservatism of its accounting policies.
If both Company A and Company B invest $10,000 in the same industry and market, and Company A consistently achieves a 20% Return On Invested Capital (ROIC) while Company B averages 10%, which would you choose?
Let's break it down:
Company A invests $10,000 and, at the end of their investment period, due to their ROIC, they amass $12,000.
($10,000 / 100 * 120% = $12,000)
Company B invests $10,000 and, at the end of their investment period, they amass $11,000.
($10,000 / 100 * 110% = $11,000)
Clearly, Company A outperforms Company B. With higher returns on its investments, Company A demonstrates a superior ability to generate cash flow and gain a growth advantage over Company B. Therefore, in general, choosing Company A would be the more lucrative option.
ROIC Examples
ROIC will always fluctuate and rarely remain steady, such as at a fixed rate of 20%. Investments like these can be likened to those in our portfolio: sometimes yielding wonderful returns, sometimes not. The crucial aspect, however, is learning and ensuring that you select companies or projects with a higher likelihood of providing greater returns. Below, I'll provide some examples to offer a clearer understanding.
Evolution AB (High ROIC)
Let's begin with one of my positions, Evolution AB. Evolution AB operates in the development, production, marketing, and licensing of business-to-business casino solutions to gaming operators. It offers live casino studios, land-based live casinos, mobile live casinos, and live casinos for television. Founded by Richard Hadida, Jens von Bahr, and Fredrik Osterberg in 2006, the company is headquartered in Stockholm, Sweden.
These are statistics from 2017 until current
Due to Evolution being a low-intensity capital business, their margins have room to expand. They can deploy cash at rapid rates and achieve high returns on a consistent basis. As of today, their ROIC is averaging 39.32%. For every dollar invested, they add 32.32 cents on top of it, resulting in an ending balance of $1.32.
Summing the values and dividing by the count:
This provides the necessary information. I observe that Evolution AB is capable of deploying cash and generating above-modest returns for its shareholders, something we prioritize in the end.
Playtech (low ROIC)
Playtech Plc, a technology company, provides gambling software, services, content, and platform technologies worldwide. The company offers technologies across various product verticals, including live casino, sports, bingo, virtual sports, and poker. It also owns the intellectual property rights and licenses the software; provides marketing and advertising, consulting and online technical support, data mining processing, turnkey, operational and hosting, live game, and video stream services; and operates betting shops. In addition, the company designs, develops, and sells software. The company was founded in 1999 and is based in Douglas, the Isle of Man.
These are statistics from 2017 until current
Playtech, a direct competitor of Evolution AB, operates in the realm of online gambling. Their average return on invested capital stands at approximately 8.97%. While they do generate profits from their investments, the returns compared to their peer, Evolution, are minimal.
Given this comparison, the choice becomes evident. Evolution AB, with its substantially higher returns and efficient capital deployment, presents a more appealing investment opportunity.
Conclusion
While ROIC shouldn't be the sole metric on which to base investment decisions, it offers a valuable insight into how effectively management is allocating capital and the success of their investments. If you're considering investing in a company and its ROIC surpasses the sector average, it's a positive indication. This suggests that the company has the ability to invest capital with a solid return, consequently generating value for its shareholders, which includes you! By analyzing ROIC alongside other key financial indicators, investors can gain a comprehensive understanding of a company's performance and potential for growth.