Understanding ROIC on Low Growth Businesses
A discussion of ROIC vs FCF yield; does ROIC matter in low growth businesses? Some current examples of high FCF yield stocks
A central part of my investment strategy is to look for good businesses that can earn high returns on capital. Companies that can sustain this over time tend to make quality long-term investments.
I get many questions on the topic of return on invested capital (ROIC). A decade ago, I felt stocks of companies that were reinvesting their earnings were in some cases quite cheap. I wrote a whole series about this (search ROIC here on BHI).
But investing is not about determining the best business. It’s about figuring out which stocks offer the most value and will compound your capital at the highest rate over time.
In some ways, I think the opportunities now are at the opposite end of the spectrum as they were in the early 2010’s. Today, I’m finding a lot of stocks with high FCF yields and low growth. These stocks have been left behind due to their seemingly unexciting modest levels of growth, but this is the opportunity for investors. A 20% FCF yield that is durable is just as good as a reinvestment moat that grows at 20% (in fact, I’d take the former over the latter in many cases because growth rates of 20% tend not to last past a few years). Of course, many 20% FCF yields are also fleeting, but there are enough examples of durable companies (some examples below).
One thing I notice in emails and feedback is that when I discuss a lower growth business, some investors question whether that valuation is justified given the lower stated ROIC’s.
I think there is a misunderstanding on how to think about ROIC in a low growth business. I posted some thoughts on this last year on X.
The misunderstanding:
People are placing too much emphasis on the stated ROIC of low growth mature companies that earn high FCF and don’t need to retain much of their earnings. It’s important to remember that the capital on a business’s balance sheet is the money that someone else invested (i.e. shareholders in past years).
If there is no place to reinvest capital going forward, then what matters going forward isn’t the ROIC (which is based on a historical balance sheet figure that is no longer relevant). What matters in this case is the FCF that we can collect going forward and the price we have to pay to acquire that FCF (i.e. the FCF yield).
For mature businesses with no potential for growth or reinvestment, it doesn’t matter what the last investor sunk into the business.
I’ll outline a simpler example: imagine a real estate developer invests $5 million to build a new apartment building that produces $200,000 of annual cash flow. This is a 4% FCF yield, or in the parlance of real estate, a 4% cap rate (technically the cap rate uses a pretax number based on what RE investors call net operating income, but we’ll ignore taxes for simplicity).
So we have a building that is earning just a 4% return on the capital the developer put into the property. Viewing this building as a “business” suggests this is a mediocre one at best: a 4% return on capital is not creating value because the investor could have likely earned better returns investing in some other real estate investment, other stocks, or some other asset class altogether. This describes what people call “cost of capital”. When it comes to cost of equity capital, it simply means the opportunity cost: the return that investors can easily achieve elsewhere.
So we have a 4% ROIC business that isn’t creating value. Let’s assume the market goes south, the developer’s business is overleveraged and on the rocks, and he decides to bring on a partner to help inject much needed cash. He offers you a 50% share of this building at a valuation of just $1.5 million. This means the price of the building declined 70% (an extreme and unlikely situation especially in multi-family, but I witnessed deals like this during the GFC in certain pockets of the market back in my real estate days).
Let’s look at your result: you invest $750k and now have a $100k of cash flow (50% share of the building’s overall annual cash flow).
This means that your return on the capital you invest is not 4% but rather 13.3% ($100k / $750k).
The same building had an original cost basis of $5 million. That was the initial capital that went into funding its development. This same asset that traded at a 4% yield now trades at a 13.3% yield. However, if you viewed the financials and crunched the ROIC for this building using GAAP financials, it would still show an ROIC of 4% because that is the capital that the original developer invested into the building.
Would this stop you from investing at a 13.3% yield (assuming you like the long-term prospects for the building)? Of course not. You would view this as a great deal.
Now, you may be thinking this example is silly because volatility like this in real estate doesn’t happen. First of all, it actually can happen in real estate1, but you’re right that a deal like this is very rare. However, it’s not rare in stocks. In fact, this type of volatility and this type of change in valuation levels happens all the time in stocks.
JPM is the largest and most followed bank in the world, and its stock price is 3 times higher than where it was just 3 years ago, a nearly 50% annual CAGR2. Even in the largest stocks in the market, there are countless other examples like this.
How does this apply to stocks? Be careful dismissing low ROIC numbers of businesses that are currently producing large free cash flows because the current earnings might not need as much reinvestment as they once did. The return on that historical investment might be poor (i.e. the developer’s $5 million), but if the asset doesn’t need replacing (or only partially replacing via maintenance capex), then the going forward distributable free cash flow might be very high (i.e. the 13% return on your $1.5 million buy price). And the return on your capital is all that matters to you as the incoming owner.
Let’s look at some real life current examples of stocks that have seen huge investment from past owners but might require less capital going forward (and thus produce higher free cash flow for new incoming owners):