The Role of ROIC - 2/n

 

Good quality business are those kinds of business that can generate higher return on the capital that is being reinvested but outstanding business are those businesses that can keep compounding the profit at higher return.

here comes the role of RETURN ON INVESTED CAPITAL - It measures the company's ability to generate operating profit at a percentage of capital that is being invested into the business. ROIC Of 25% means that for every ₹100 the company has invested into the business that could be funded by either internally or from outside whether through debt or equity generates ₹25 profit annually.

ROIC =                                 NOPAT (EBIT*1-Tax)

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               Investment Capital (Fixed Assets + Net Working capital)

 

According to Charlie Munger emphasized that investing in businesses capable of compounding high returns on invested capital (ROIC) can lead to outperformance, even if the initial purchase price is above fair value.

High quality businesses tend to generate high returns on invested capital (ROIC). Charlie says over the long-term a businesses returns will mirror its returns on capital. Make it a priority to build a portfolio of high and sustainable ROIC businesses.

"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result. "

But a high return on invested capital is not enough to achieve the compounding growth rate if the business is not able to find consistent new opportunities to reinvest their profit directly into the business, therefore we also have to look at the reinvestment rate which can be measured as growth in invested capital related to the net operating profit.

Reinvestment rate = Capex + changes in WC/CFO