John, I'm just searching through Bing for your old posts and I'm learning an incredible amount so thank you for what you do here. I'll admit I'm clueless about this stuff (I'm teaching myself about all of this) so forgive the following question if it's a bit simplistic:
"Using the example above, a company that can grow at 8% and needs half of that 5% earnings yield to grow will compound at 10.5% (still a nice long term rate of overall growth). If such a company is bought at a low price, the third engine (P/E multiple expansion) could lead this to be a successful investment. This is a good business because half the earnings are invested at a 16% ROIC (which produces 8% growth since half of the earnings are invested). This company will create value at that rate of ROIC, and the other 2.5% (the other half of the earnings) can be sent back as a dividend or buyback."
Do you just double the 8% sales growth rate to figure out the ROIC of the company in this example? Is this the quickhand way you figure out ROIC for a company you stumble onto out in the wild?
Great question. So let's use a simple example of a stock with a $100 share price, $5 earnings per share (20 P/E aka 5% earnings yield). Let's also assume the company retains half of its earnings (so $2.50 per share) and reinvests those earnings at a 16% ROIC.
The result of this retained reinvestment is: $2.50 * 0.16 = $0.40 per share earnings growth, and $0.40 on the $5 eps is 8% growth.
But, keep in mind the company also has the other $2.50 of eps that they didn't retain. This can be paid out as a dividend (or a buyback). $2.50 dividend on $100 share price is 2.5%.
This is how I get my 10.5% (8% growth + 2.5% dividend yield).
The way to think about it is this: a company will grow at the product of two factors: incremental ROIC x reinvestment rate. (in this example, this is 16% x 50% = 8%)
In terms of calculating ROIC, I do think of this as incremental ROIC as Larson points out below. The way to think about it is: how much of the company's earnings does it retain and what are the returns on those earnings? How much growth results from those retained earnings? That's incremental ROIC. Additional profit divided by additional capital needed to achieve that new profit.
Hi David - I echo your comments about John’s writing, it’s very valuable stuff. Just seeing this now but the 16% is just a plug figure that John is using here. He defines growth in the following equation: Growth = reinvestment rate * ROIC.
So in this example, our equation would be: 8% = 50% (as he mentions they use half of their earnings) * X
You can solve for ROIC this way. But to your point about how you figure out ROIC “in the wild”, it need not be computed this way. Return on invested capital can commonly be defined as some measure of earnings divided by some level of capital. Most use NOPAT (Net operating profit after tax, defined as EBIT * 1 - tax rate) / Invested capital (debt + equity - cash, some also strip out intangibles like Goodwill).
Quick example and profile to illustrate, assume a company has the following:
$100 in cash
$50 in goodwill
$250 in debt
$400 in equity
$75 in EBIT
25% tax rate
You’ll get NOPAT of 56, and invested capital of 500, giving you an ROIC of ~11%.
Notably, the figure John is using here is actually return on INCREMENTAL capital, which is similar but slightly different. John links an article where he shows how he calculates it, but in basic terms, it’s the change in earnings divided by change in invested capital over a certain time period. He describes it much more eloquently than I, so please check that post out for clarity
John, I'm just searching through Bing for your old posts and I'm learning an incredible amount so thank you for what you do here. I'll admit I'm clueless about this stuff (I'm teaching myself about all of this) so forgive the following question if it's a bit simplistic:
"Using the example above, a company that can grow at 8% and needs half of that 5% earnings yield to grow will compound at 10.5% (still a nice long term rate of overall growth). If such a company is bought at a low price, the third engine (P/E multiple expansion) could lead this to be a successful investment. This is a good business because half the earnings are invested at a 16% ROIC (which produces 8% growth since half of the earnings are invested). This company will create value at that rate of ROIC, and the other 2.5% (the other half of the earnings) can be sent back as a dividend or buyback."
Do you just double the 8% sales growth rate to figure out the ROIC of the company in this example? Is this the quickhand way you figure out ROIC for a company you stumble onto out in the wild?
Hi David,
Great question. So let's use a simple example of a stock with a $100 share price, $5 earnings per share (20 P/E aka 5% earnings yield). Let's also assume the company retains half of its earnings (so $2.50 per share) and reinvests those earnings at a 16% ROIC.
The result of this retained reinvestment is: $2.50 * 0.16 = $0.40 per share earnings growth, and $0.40 on the $5 eps is 8% growth.
But, keep in mind the company also has the other $2.50 of eps that they didn't retain. This can be paid out as a dividend (or a buyback). $2.50 dividend on $100 share price is 2.5%.
This is how I get my 10.5% (8% growth + 2.5% dividend yield).
The way to think about it is this: a company will grow at the product of two factors: incremental ROIC x reinvestment rate. (in this example, this is 16% x 50% = 8%)
In terms of calculating ROIC, I do think of this as incremental ROIC as Larson points out below. The way to think about it is: how much of the company's earnings does it retain and what are the returns on those earnings? How much growth results from those retained earnings? That's incremental ROIC. Additional profit divided by additional capital needed to achieve that new profit.
This matches what I read in michael mauboussin's articles and books as defined
Thank you for taking the time to answer this, John.
Hi David - I echo your comments about John’s writing, it’s very valuable stuff. Just seeing this now but the 16% is just a plug figure that John is using here. He defines growth in the following equation: Growth = reinvestment rate * ROIC.
So in this example, our equation would be: 8% = 50% (as he mentions they use half of their earnings) * X
You can solve for ROIC this way. But to your point about how you figure out ROIC “in the wild”, it need not be computed this way. Return on invested capital can commonly be defined as some measure of earnings divided by some level of capital. Most use NOPAT (Net operating profit after tax, defined as EBIT * 1 - tax rate) / Invested capital (debt + equity - cash, some also strip out intangibles like Goodwill).
Quick example and profile to illustrate, assume a company has the following:
$100 in cash
$50 in goodwill
$250 in debt
$400 in equity
$75 in EBIT
25% tax rate
You’ll get NOPAT of 56, and invested capital of 500, giving you an ROIC of ~11%.
Notably, the figure John is using here is actually return on INCREMENTAL capital, which is similar but slightly different. John links an article where he shows how he calculates it, but in basic terms, it’s the change in earnings divided by change in invested capital over a certain time period. He describes it much more eloquently than I, so please check that post out for clarity
Hope this helps.