Friday, October 16, 2015

Pay Up for High ROIC! (Part 1)

Part 2 is out!

In financial math, high ROIC or return on invested capital can justify almost any PE to buy. This is what this post strives to illustrate. Do read on, it's really important! Promise you won't waste your time. Invested capital simply accounts for all the capital that businesses need: equity and debt. ROE which stands for return on equity, does not take into account of debt. In the financial world, most people talk about ROE but essentially both ROIC and ROE are about how much we can get back by putting in $100.

The genesis of this post comes from:

Some businesses are inherently very strong and generates huge cashflows. For every $100 that we put into the business, we could be making $20. That's ROIC of 20%. One example could be the potato chips business. Raw materials are essentially potatoes and packaging materials which cost next to nothing and what matters is the ability to put it into shelves around the world, in the 7-11s, the Tescos and the mom-and-pop stores all across the planet. Well, this, my friends, is the business moat: global distribution networks that takes years, if not decades to build. The world's biggest potato chips maker had shown that ROIC of this business is pretty high. That's Frito Lay or Pepsico, the listed parent entity.

Don't we all love Frito Lay?

For simplicity let's assume that the potato chips firm can generate 20% ROIC (Pepsico does around 15%). We further assume that in Year 1, its earnings per share or EPS is $1. Because of it's ability to return 20%, this $1 will make $0.2 in Year 2 and together with the original ability to make $1, EPS in Year 2 is $1.2. As we can see, this is compounding at work, So Year 3 will be $1.44 and Year 10 EPS is a whopping $6.2. Assuming that we paid $20 for the EPS $1 in Year 1, ie paying up 20x PE, what is our return after 10 years? It's phenomenal! (All this math is in Table 1 below)

The original capital of $20 now generates $6.2 i.e. over 30% return, over the next decade, it will generate more than the original capital in one single year (Year 17 to be exact). If we assume that it trades at 10x PE at Year 10 (which is ridiculously cheap, remember we bought it at 20x PE), the stock will be worth $62 (ie more than double our original purchase price or around 7%pa using our rule of 72. In Year 17, when EPS is $22.2, more than two dollars higher than our purchase price, the same stock should be worth around $222 dollars at 10x PE. So, in a nutshell, what we bought at 20x PE became a ten bagger. Thanks to its ROIC!

Table 1

In Year 20, using the same methodology, the same stock will be worth $383 while generating almost twice the our original capital ($20) in  EPS (of $38) in a single year. This is why we pay up for high ROIC!

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