#33 - The Relationship of ROIC, Growth, Yield and Margin of Safety
June 19, 2020: A narration of incoherent thoughts I had trying to grapple with why ROIC matters, its relationship with valuation (i.e. IRR) and trying to look at margin of safety differently. A revelation of how little I know and how I noodle investing concepts.
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Episode Notes:
My Thoughts:
Original premise started by asking why ROIC mattered. Munger has famously said over the long time the ROIC on the business it would you should expect to get on the stock. Now, many will argue you still cannot ignore valuation.
So, if I used IRR as a valuation metric, how does that factor in with ROIC?
The relationship with IRR and Growth is that the two combined (using IRR as Owner Earning’s Yield) should return the ‘expected return’. This can mean different things to various people but for me if the return I want on an investment is 15%…. Which would also be what my discount rate (i.e. opportunity cost) then if an IRR of a business was 8%, then I would need 7% growth. A 7% growth in owner’s earnings.
But it's really hard to measure growth on owner’s earnings. So, I like to look at the top line and consider sales growth. So where does ROIC factor in?
Well, ROIC would particularly be important for a growing business. If a business did not grow… then the IRR should be sufficient for investors to understand what they are getting. A 8% IRR for a business that no longer grows is practically like a bond that returns 8% in dividends….
ROIC matters if the business is seeking to reinvest its capital back into the company (internal + external means). So, a relative comparison of ROIC between investments is one use for ROIC. A business that has a 50% ROIC vs. a business that has a 30% ROIC will provide a higher return for reinvesting its capital. Now, the return on incremental invested capital should be a better indicator but that is an awfully hard number to calculate.
Maybe if companies shared the IRR of new customers (a possibly refined version of the LTV/CAC ratio), then we could have a better idea of whether the business can truly reinvest at a high rate. But most do not share enough information. So, the historical execution and stability of ROIC is often used as a proxy for the company+management’s ability to reinvest capital at high rates to the future.
Okay. So how does this all play in?
The IRR I’m calculating is a result of the historic ROIC. And, the growth I am forecasting to make up my expected return is going to be the product of reinvesting the current IRR at the ROIC I’m leveraging from the past.
So, if I had a business with some 50% ROIC at a IRR of 3%…. To get a 15% expected return I would be considering a growth of 12%. There are many factors I have to consider in regards to the reasonability of considering the growth.
Assuming the competitive advantages are strong, the market exists, and the management has a track record of executing… in some ways, I’m using the ROIC as another point of reference to gain a kind of certainty on the growth I’m forecasting. Because, I’m forecasting that not only will the top line grow by some x% but that the reinvestment of my 3% IRR will yield some 50% return that will be reinvested.
Then I thought about margins… If a business were to continuously reinvest at a high clip, then I would expect to see margins on owner’s earnings increase right? Because the business is earning more and more with each reinvestment. This would continue to be true if growth is true and the business can maintain a high ROIC.
Now, if growth does not exist and the company continues to reinvest into the business… then that could be considered to be destroying value and the ROIC of the business would probably decline. However, this would probably be the case for developments that have long cycles of reinvestment.
So what was all this for? I wanted to think through why any of this mattered. Why would some investors focus on ROIC, some on yield, some on growth… and/or how various factors should be considered in tandem.
As I consider the margin of safety in businesses, the fundamental place to identify them seem to be in the IRR. If a business yields 15% and has a solid competitive advantage, then that is great. But its ROIC may be 15% and growth may be at best 10%. Which is pretty solid. But given the ROIC of 15%, does that mean that I should expect the business to return 15% over the long term and that since I purchased it at a 15% yield I have a solid margin of safety that doesn’t guarantee the returns but gives me a higher likelihood of realizing it? I think so.
But if a business had a ROIC of 50%, but a yield of 3%… a solid competitive position.. I may not have much of a margin of safety by the previous standards. The business may have been growing 30% annually but who knows what the future holds. But maybe the margin of safety exists in the company’s moat. A moat that will allow the business to reinvest at extremely high rates. Over the course of holding the business for a long time, should I expect a 50% return despite purchasing it at a 3% yield? That’s a lot of growth and reinvestment of the growth to foster more growth that I’m assuming.
So, is the most standard form of margin of safety… maybe a ’surer’ form?… to look at ROIC vs. IRR and the disparity between the two as the amount of margin of safety? Possibly. But that may be the obvious one. I just think anything quantifiable is not much of an edge. I say this all well knowing Renaissance has been making most look like amateurs.
Maybe its just the part of me that thinks people who tell me the latter scenario as not making sense are the ones who are not making sense. Because, if you wished to own a business that could compound at 30-40% annually… wouldn’t you want to own a business with a high ROIC? The current yield may be 3% but if the market could easily support a 12% growth but there was also room for upward growth… wouldn’t there be considered to be a margin of safety?