The Role of ROIC - the Hashim Amla of understanding business characteristics

Return on Invested Capital (ROIC) is a financial metric that evaluates the return a company earns on the funds invested in its operations. It helps assess whether growth adds or diminishes value. Growth creates value when ROIC exceeds the cost of capital (ROIC > COC), but erodes value when ROIC is less than the cost of capital (ROIC < COC).

Picture a company as a chef cooking a meal. NOPAT is the delicious dish served to the table (the profits generated), while Invested Capital is the ingredients used from the pantry (the resources invested). The best chef (business) creates the most flavorful meal with the fewest ingredients.

imagine 2 companies company a and company b both having the earning of ₹100. Suppose that the both the companies would like to grow their earnings by 10% over the next year. What would it take for each company to achieve that? How much capital would each company have to invest to grow their earnings by 10% next year?

Well, it clearly depends upon what kind of return are the companies able to generate and what kind of return the company would be able to achieve if it reinvents the capital into the business meaning how much additional profit can the company create for each rupees of capital that is being reinvested into the business. Suppose company a can earn ROIC of 20% meaning for every rupee it reinvest into the business, it earns 20% of the capital back into the business in form of additional profit. In order to grow its overall profit by 10% it would need to reinvest 50% of next year's profit, since 20% of 50% is 10%. Meaning company A would be able to generate a free cash flow of 50% back to the shareholder either as cash dividend or just retaining in the balance sheet.

At the same time company B is not as attractive business as company A it doesn't have any strong moat , it can only earn 10% ROIC, in order to attain a profit growth of 10% company B needs to reinvest 100% of the earning leaving no money to be distributed to shareholders or no remaining amount of free cash flow to the firm.

From the above example of company and Company B it illustrates clearly that there is an equation that is able to define the relationship between the profit growth of the company and ROIC, the relationship is reinvestment rate.