📊 ROIC vs ROIIC
You probably already heard about ROIC.
It’s a very important metric as it looks at the capital allocation skills of management.
But have you ever heard about ROIIC? Let’s teach you everything you need to know today.
Return on Invested Capital (ROIC)
Let’s first refresh your memory and look at Return on Invested Capital (ROIC).
The ROIC shows how efficiently management is using its capital.
Here’s how you calculate it:
ROIC = NOPAT / Invested Capital
NOPAT = Net Operating Profit After Tax
Invested Capital = Total Assets – Non-Interest-Bearing Current LiabilitiesIf a company has a ROIC of 30%, it means it generates $30 in profit (after tax) for every $100 you invest as a shareholder.
The higher the ROIC, the better. As a general rule, we look for companies with a ROIC above 15%.
Here’s what Charlie Munger has to say about return on capital:
Here are some interesting quality stocks with a ROIC > 15%:
You want to learn even more about ROIC? Read this article.
Return on Incremental Invested Capital (ROIIC)
Warren Buffett said the following in his annual shareholder letter of 1992:
"The best business to own is one that, over an extended period, can employ large amounts of incremental capital at very high rates of return."ROIIC stands for Return on Incremental Invested Capital. It’s a very important but often overlooked metric.
The ROIIC shows how efficiently a company generates returns on the new capital it invests.
Here’s how you calculate it:
ROIIC = Change in NOPAT / Change in Invested Capital
In other words:
ROIIC = (NOPAT Year 2 - NOPAT Year 1) / (Invested Capital Year 2 - Invested Capital Year 1)So the difference between the two formulas looks as follows:
ROIC = NOPAT / Invested Capital
ROIIC = Change in NOPAT / Change in Invested CapitalFor example, a ROIIC of 20% means that for every extra $100 a company invests, it generates $20 in additional profit for you as a shareholder.
The higher the ROIIC, the better. Look for companies with an ROIIC over 15%.
You don’t want to calculate the ROIIC yourself? There is a handy workaround you can use.
When a company’s ROIC gradually increases over the years, you know the business has a high ROIIC.
Visa is a perfect example of this:
Here’s a onepager with the essentials of ROIIC:
Let’s use an example to clarify this concept:
You run an ice cream shop with an initial investment of $50,000
You earn a profit of $10,000 each year
You decide to buy a second ice cream machine for $5,000
One year later, that new machine helped you make an extra profit of $2,000.
Here’s what your ROIIC number looks like:
ROIIC = (NOPAT Year 2 - NOPAT Year 1) / (Invested Capital Year 2 - Invested Capital Year 1)
ROIIC = ($12,000 - $10,000) / ($55,000 - $50,000) = 40%The extra ice cream machine generates a ROIIC of 40%. That’s an amazing result.
As an owner of this ice cream shop, you should make this investment every single day.
ROIC versus ROIIC
ROIC measures the return on total invested capital, while ROIIC only looks at the new additional investments a company makes.
A high ROIC is a great indication that the company has a competitive advantage.
But what about the ROIIC?
The ROIIC gives you an indication of whether the competitive advantage is widening or not.
It’s essential to note that a company’s moat is widening or shrinking every single day. You want to invest in companies that are widening their moat.
Why ROIIC matters
Let’s bring Return on Incremental Invested Capital (ROIIC) to life with another example.
Let’s compare two companies: Low Quality Inc (ROIIC: 5%) and High Quality Inc (ROIIC: 20%).
Both companies start with the following in year 0:
$100 million in profit (NOPAT)
$500 million in invested capital
100% of profits reinvested each year
Year 1
In year one, the total profit will look like this:
Low Quality Inc:
Capital in year 0: $500M
Profit in year 0: $100M
Capital Reinvested: $100M
New Invested Capital in year 1: $500M + $100M = $600M
Incremental Capital: $100M
Incremental Profit: $100M × 5% = $5M
Total Profit in Year 1: $100M + $5M = $105M
These numbers make sense when you calculate the ROIIC:
ROIIC = (NOPAT Year 1 - NOPAT Year 0) / (Invested Capital Year 1 - Invested Capital Year 0)
ROIIC = ($105M - $100M) / ($600M - $500M) = 5%High Quality Inc:
Capital in year 0: $500M
Profit in year 0: $100M
Capital reinvested: $100M
New Invested Capital in year 1: $500M + $100M = $600M
Incremental Capital: $100M
Incremental Profit: $100M × 20% = $20M
Total Profit in Year 1: $100M + $20M = $120M
ROIIC = (NOPAT Year 1 - NOPAT Year 0) / (Invested Capital Year 1 - Invested Capital Year 0)
ROIIC = ($120M - $100M) / ($600M - $500M) = 20%Year 2
Let’s take a look at the numbers for year 2:
Low Quality Inc:
Capital in year 1: $600M
Profit in year 1: $105M
Capital Reinvested: $105M
New Invested Capital in year 2: $600M + $105M = $705M
Incremental Capital: $105M
Incremental Profit: $105M × 5% = $5.25M
Total Profit in Year 2: $105M + $5.25M = $110.25M
ROIIC = (NOPAT Year 2 - NOPAT Year 1) / (Invested Capital Year 2 - Invested Capital Year 1)
ROIIC = ($110.25M - $105M) / ($600M - $705M) = 5%High Quality Inc:
Capital in year 1: $600M
Profit in year 1: $120M
Capital Reinvested: $120M
New Invested Capital in year 2: $600M + $120M = $720M
Incremental Capital: $120M
Incremental Profit: $120M × 20% = $24M
Total Profit in Year 2: $120M + $24M = $144M
ROIIC = (NOPAT Year 2 - NOPAT Year 1) / (Invested Capital Year 2 - Invested Capital Year 1)
ROIIC = ($144M - $120M) / ($720M - $600M) = 20%As you can see, High Quality Inc. is a better company than Low Quality Inc.
Can you guess how much more NOPAT High Quality Inc would have compared to Low Quality Inc after 20 years?
In year 20, Low Quality Inc would have a NOPAT of $265 million. Not bad, right?
But guess how much profit High Quality Inc. would earn if it managed to compound at 20% per year for 20 years?
The answer is $3.8 billion!
That’s 14 times more than what Low Quality Inc has!
Finding Compounding Machines
The best companies in the world? Very profitable businesses with a high ROIIC that can reinvest almost everything to grow their business.
That’s how Compounding Machines are created.
If you can find a Quality Stock that can reinvest 100% of its Free Cash Flow to grow organically, you’ve found a golden goose.
It’s exactly why the Reinvestment Rate is so important.
The Reinvestment Rate is the percentage of a company’s profit that it puts back into the business.
You can calculate the Reinvestment Rate as follows:
Reinvestment Rate = EPS Growth Rate / ROICThis formula shows what portion of a company's ROIC is being reinvested to achieve its long-term earnings growth.
Sounds difficult? Let’s use an example.
Let’s say you run a lemonade stand.
You earn a $20 profit for every $100 you put into your stand.
→ This means your ROIC is 20%You want to grow your business by 10% each year in the long term.
→ To do this, you need to sell more lemonade, buy more cups, or set up a second stand
Your Reinvestment Rate would be:
Reinvestment Rate = EPS Growth Rate / ROIC
Reinvestment Rate = 10% / 20% = 50%So…
You need to reinvest 50% of your profit to grow by 10% each year.
If you made a $100 profit, you could:
Reinvest $50 to grow your business and distribute the other $50 to shareholders.
But what if the ROIC is 40% instead of 20%?
Here’s what the Reinvestment Rate would look like in that case:
Reinvestment Rate = Long-Term EPS Growth / ROIC
Reinvestment Rate = 10% / 40% = 25%You now only need to reinvest 25% of your profit to achieve the same growth rate.
This means you can distribute $75 instead of $50 to shareholders. There’s more cash available to return to shareholders. Nice!
The conclusion? A higher ROIC means a company can achieve the same level of growth with fewer reinvestments.
We like companies with a high Reinvestment Rate and ROIC.
This way, the company can grow at very attractive rates.
Reinvestment Rate of Our Portfolio
Let’s take a look at the Reinvestment Rate of all companies in Our Portfolio: