Tag Archives: MROIC

Returns of 100 to 1? First Understand Returns on Incr. Capital; Reader’s Question

Cap investments

The best long-term investments tend to be companies that can reinvestment over and over again at high rates of return.  Those high rates of return attract competitors so you must also understand barriers-to-entry.  But first study how to calculate incremental returns on capital or marginal returns on invested capital (“MROIC”).   There are several links and documents below to help you.  The effort is worth it if you can find: WMT_50 Year SRC Chart (up to 2000). WMT had regional economies of scale until it out-grew them. 

From John Huber of Base Hit Investing

  1. Eridon855 says:

May 30, 2016 at 10:44 am

Is there a way to calulate return on reinvested earnings?

  • John Huber says:

May 30, 2016 at 2:57 pm

One quick and dirty way is to look at the amount of capital the business has added over a period of time, and compare that to the amount of incremental growth of earnings. Last year Walmart earned $14.7 billion of net income on roughly $125 billion debt and equity capital, or just under 12% return on capital. Not bad, but what we really want to know if we are going to buy Walmart is a) how much of their earnings will they retain and reinvest in the business going forward? and b) what will the return on that reinvested capital be?

10 years ago in fiscal 2006, Walmart earned $11.2 billion on roughly $83 billion of capital, or around 13.5%. But in the subsequent 10 years, they invested roughly $42 billion of additional debt and equity capital ($125b invested in 2016 and $83b invested in 2006), and using that incremental $42 billion they were able to grow earnings by about $3.5 billion (earnings grew from $11.2 billion in 2006 to around $14.7 billion in 2016). So in the past 10 years, Walmart has seen a rather mediocre return on the capital that it has invested during that time (roughly 8%).

We can also look at the last 10 years and see that Walmart has retained roughly 35% of its earnings to reinvest back in the business (the balance has been primarily used for buybacks and dividends). As I’ve mentioned before, a company will see its intrinsic value will compound at a rate that roughly equals the product of its ROIC and its reinvestment rate. So if Walmart can retain 35% of its capital and reinvest that capital at an 8% return, we’d expect a modest growth of intrinsic value of around 3% per year. Stockholders will see total returns higher than that because of dividends, but the value of the enterprise will likely compound at roughly that rate. And we can see that over the previous 10 years, Walmart’s stock has grown around 45% not including dividends. So unless you are banking on an increase in P/E ratios, you’re unlikely to achieve a great result buying a business that can only invest a third of its earnings at 8% returns.

This is a really rough measure, and this back of the envelope method works okay with a large, mature company like Walmart. But what you really want to know is what will the business retain going forward and what will the return be on the capital it retains and reinvests? Of course, there are different ways to measure returns (you might use operating income, net income, free cash flow, etc…) and there are many ways to measure the capital that is employed. But hopefully this is a helpful example from a general point of view.

Calculating Incremental Returns on Capital

ALSO, read and study these articles:http://basehitinvesting.com/tag/roic/

For extra study go here:

Reader’s Question

Hi John,
I love the “no hope” strategy for finding ideas. See http://csinvesting.org/2016/06/04/search-process-no-hope-dry-bulk-shipping/

I suppose there is always headline risk with things that have been in multi-year bear markets.

I am curious if you have any thoughts about political consequences of increased isolationist sentiment in the US and Europe?   Reply: Actually, the recent sell-off in the shippers this past week (June 17th, 2016) has partially been (I believe) due to Brexit.  You always want to look where sentiment is the worst and then try to determine if the price reflects the known news.   So on the one hand the rising fears over isolation give me comfort that a lot of bad news is being priced in.  Also, if the EU breaks up, why should trade go down?   Britain already sells more to the EU than it imports.   Switzerland isn’t in the EU and it has one of the strongest economies in Europe.   The EU makes no logical economic sense–how can central planning EVER work?  Nations have a natural interest to trade with each other since individuals benefit. What Trump says and can do (even if elected) are two separate issues.   I really don’t know how to handicap.   What I want is terrible news to encourage ship owners not to order new ships and to scrap the ones that they have.  

Also curious about your thoughts on the surge in low-cost vessels that came from Chinese ship makers in the last several years.   Reply:  This has been one of the reasons this shipping cycle has been the worst in forty years.   Easy credit/subsidized loans created a boom in Chinese ship builders (See May 7th, 2016 Economist issue and http://www.economist.com/news/leaders/21698240-it-question-when-not-if-real-trouble-will-hit-china-coming-debt-bust.  Now some Chinese ship builders are close to bankruptcy.   So, yes, this oversupply will make this cycle–already a long one–drag out, but who knows for how long?.

I subscribed to Trade Winds (shipping trade magazine) a couple of years ago, to keep abreast of the industry and try to find when industry sentiment started to pick up. So far, it’s still been abysmal, although this years spike in iron ore was pretty interesting. Especially because Wall Street analysts are still telling everyone iron ore is going lower and this is just a blip.  Reply: Wall Street just tells you AFTER the fact or projects the trend/obvious.    As one ship owner said (Diana Shipping) said, “The bulk shipping market will turn when no one believes it will turn.”   

Ordered the book just now. Really interested to learn more about the industry, and it’s cool that it’s in novel form. I think some of these shippers may start getting close to scrap value pretty soon.  Reply: The Shipping Man was an educational and enjoyable read.   I may even search for other book like Viking_Raid_Excerpt


Just remember that the shipping industry has big demarcations. A company like Navigators’ Holdings (an LPG shipper) has different market dynamics than a dry-bulk shipper like Scorpio Bulkers.   One shipper operates in more of a oligopoly market than a purely competitive one though both, obviously, are cyclical.

I highly recommend the 800 page opus, Maritime Economics (3rd Edition) by Martin Stopford. If you wish to dig into the shipping industry, then read the annual reports/presentations of several shippers.   I have a ways to go to understand this market. The author: https://youtu.be/e2TToPf5iDs

Speculating in shippers is a bit like playing poker.  You don’t want the ship owners to start ordering new ships if freight rates start to rise.   You want the other owners to disbelieve a sustained rise.  When supply is constrained for a few years coupled with a spike in demand, the shipping market explodes like in 2007–no wonder a large supply of ships eventually came into the market and the boom went to bust.  The SIZE of the prior boom has led the depth of this bust.

Questions on Chapter 4

ABOOK-Feb-2015-Buybacks (1)

The Acquirer’s Multiple Ch 4 in DEEP VALUE  is where we left off in discussing Chapter 4.

Imagine diligently watching those stocks each day as they do worse than the market average over the course of many months or even years….The magic formula portfolio fared poorly relative to the market average in five out of every 12 months tested. For full-year period…failed to beat the market average once every four years. Joel Greenblatt discusses the role that loss aversion plays in deterring investors from following his ‘magic formula’. (Montier)

A Summary

Greenblatt reinterpreted Buffett’s return on equity capital measure as RETURN ON CAPITAL, which he construed as the ratio of pre-tax operating earnings (earnings before interest and taxes, or EBIT or EBITDA-MCX or operating earnings that are sustainable) to tangible capital employed in the business (Net Working Capital + Net Fixed Assets) defined as:

Return on Capital = EBIT divided by (Net Working Capital (NWC) + Net Fixed Assets)

The use of EBIT makes the return on capital ratio comparable across different capital structures. EBIT makes an apples-to-apples comparison possible.

For tangible capital Greenblatt uses NWC + Net Fixed Assets rather than total assets to determine the amount of capital each company actually requires to conduct its business.

The higher the return on capital ratio, the more wonderful the company.

To determine a fair price, Greenblatt uses earnings yield, which he defines as follows:

Earnings Yield = EBIT divided by Enterprise Value (EV).

EV gives a more full picture of the actual price an acquirer must pay than market capitalization alone.  EBIT is agnostic to capital structure so we can compare companies on a like-for-like basis.

The higher operating earnings are in relation to enterprise value, the higher the earning yield, and the better the value.

Greenblatt has quantified Buffett’s wonderful company at a fair price strategy.

Enterprise Multiple (EV) = EBITDA divided by EV or (EBITDA – Maintenance Capital Expenditures) divided by EV.


The EV to EBITDA ratio is useless without a discussion on asset lives, capital intensity, technological progress or revenue recognition.

EBITDA, or any of its derivatives (EBDIT, EBITDAR, etc.) is simply a crude measure of gross cash flow.

The gross cash flow margin is simply a measure of the capital intensity of the business.   A manufacturing business will have a significantly higher gross cash margin than, say, a retailer, because it needs to pay for the capital (via in the accounting sense the depreciation charge) of all its plant and equipment which consumes more of it than a superstore.

What matters is not gross cash flow but net of free cash flow, which is the amount of cash available after reinvestment.

Case Study:

In the heyday of the technology bubble, the EV to EBITDA ratio was a favorite among telecom analysts.   Sadly, as new entrants came into the system and pushed up the price of the UMTS licenses (the third generation of mobile networks) to insane levels, the cost of replacement went sky-rocketing; expected free cash flow plummeted, and the telecom shares got more and more ‘attractive’ on an EBITDA basis, which could not capture any of this.   Eventually, some went bankrupt, some had to undergo a debt rescheduling exercise or issue new capital, and all saw their share price collapse.

James Murray Wells, a 21-year-old law student in Bristol, UK, needed a pair of glasses, and was faced with a bill of 150 stg.   He found that the manufacturing cost off standard spectacles (frame and glasses) was less than 10 stg.   This prompted Mr. Murray Wells to set up an Internet-based company to challenge what he claimed was a lack of price competition among the four major high street opticians in England.  Three months into his venture, he was selling hundreds of pairs for as little as 15 stg to apparently delighted customers.

The replacement value of the asset, ‘making spectacles and selling them’ is rather low.   A 21-year old student with no expertise in the field is apparently able to replicate it from his student room, with a few thousand pounds borrowed from his father.   On the other hand, the market value is enormous because, as previously discussed, it equals the net present value of free cash flow discounted to infinity.

The market value is a direct function of the economic profitability of the asset in question and, in this example with a cost of goods sold at 10 and sales at $150, it is plain that economic value added is truly staggering.   Making spectacles and selling them has a high ROIC, and an equally impressive asset multiple—the ratio of market value to the replacement value of invested capital.

If the entrepreneur is successful in his venture, he will collapse the marginal return on capital invested of the industry by accepting a lower margin than his competitors.   The entrepreneur made an arbitrage between the market value of existing capacity and the replacement value of new capacity, which he found cheaper to create.

Investors in incumbent firms my find out that they have paid too much for the economic value of their asset in the belief that a very high economic return on capital invested was sustainable.   Investors who ignore the workings of the capital cycle, the ultimate driver of share prices, do so to their disadvantage.

Investment should just be a replication of the process of arbitrage between market value and replacement value. Good stock pickers are brilliant strategy analysts.   They understand the business case for the company. (TATOO that to your forehead!)


Why is the EV so good at identifying undervalued stocks?

What drives the returns of the magic formula? What Metric?  What does this mean for us as Deep Value Investors?

Assuming you read the entire chapter, what two main points about investing did you learn?  Anything surprise you?

Supplementary Readings:

What Has Worked in Investing by Tweedy Browne   Why do low price-to-book, low price to cash flows, etc tend to generate higher returns than a market average?  What is the principle behind the returns?  Also, note the Richard Thaler link below for a hint.

When an investor turns to the research on regression to the mean and investors overreacting to poor company performance/bad news in Richard Thaler research, he or she sees that prices of the winner and loser portfolios take three-to-seven years to revert.  See also The New Finance: The Case Against Efficient Markets by Robert A. Haugen and Inefficient Markets by Andrei Schleifer.

Next, we will focus on Mean Reversion and ROIC.

Death Taxes and Reversion To The Mean (Mauboussin)


Dale Wettlaufer on ROIC and MROIC  a series of Fool.com articles

EconomicModel of DFC_ROIC The author uses NOPAT (after-taxes). I placed this here for those who wanted to see how others determine value.

We will review the second half of the chapter next.





A Reader’s Question on ROIC and MROIC, Goodwill and Clean Surplus Accounting

S.A. Nelson’s little book, The ABC of Stock Speculation, cites the basic opportunity for manipulation in these words: “The great mistake made by the public is paying attention to prices instead of to values.” What do we mean by paying attention to prices rather than values? Human nature is one of the few constants in an ever-changing world:  “It is only fair to say that the public rarely sees value until it is most markedly demonstrated to them, and the demonstration comes generally at a pretty high price. It is easier for them, as experience shows, to believe a stock is cheap when it is relatively dear, than to believe it is cheap when it is more than cheap.”

A Reader Asks about ROIC and MROIC (Marginal Return on Invested Capital)

I have been thinking about return on capital. My understanding is that one thing Greenblatt is trying to do come with in his Magic Formula is an incremental return on capital – that’s why he excludes things like goodwill. He’s arguing that it’s the return he can get on the assets that actually exist that’s important.

JC: True

I’ve expressed scepticism about this before, arguing that increases in earnings often come through acquisitions, and therefore goodwill was/is a true capital cost (if the company didn’t need to spend money on goodwill, then why did it?).

Well, this got me to thinking – if what you’re really trying to ascertain is a company’s incremental return on capital – then why not CALCULATE an incremental return on capital, rather than some surrogate? The formula is simple enough (and nothing new, I didn’t invent the idea):


There are some nuances, like whether you want to use EBIT figures or net income, adjusting for share issues, and so on. But you could use something like EBIT in the numerator, and total capital in the denominator.

What are your thoughts on this?

JC: You should look at a company both ways. What are the returns on the net tangible assets employed AND what are the incremental returns on capital employed in the business.  We only have a few more chapters in Competition Demystified and then I will begin a long series on valuation-the death march.

For now, you may get some insight here:Dale Wettlaufer on ROIC and MROIC, EconomicModel of ROIC_EVA_WACC and ROIC and the Networking Industry.

You are not the only investor to be skeptical about IGNORING GOODWILL. See page four in this article:Why bad multiples happen to good companies. Cisco (CSCO) CSCO_VL, for example, has a high ROIC–so you will find it on http://www.magicformulainvesting.com/welcome.html but much lower ROC (Return on total capital) due to many acquisitions that were acquired with goodwill. Yes, investors are laying out real dollars, so you need to track the success over time (rolling average of a few years) of those acquisitions.

Question on Clean Surplus Accounting

OK, very interesting John. I’m reading the book Book-on-Buffett-Methods-of-Clean-Surplus . I’ve only got to page 65, but I’m seeing the idea. The author uses a LOT of words to describe a very simple concept.

JC: Agreed. The author says in 230 pages what he could say in 3.

What’s very interesting is that by stuffing a lot of so-called one-off charges through the P&L, a company is able to “juice” its returns for the year, creating an artificially high ROE for subsequent years. Does it mean that clean surplus accounting paints too rosy a picture of a company? The answer is: probably not. With clean surplus accounting, all that “juicing” gets accumulated into the retained earnings of the company, so that in subsequent years, assuming the absence of further exceptional items, returns will actually come out lower. So in effect, clean surplus accounting isn’t being fooled by these non-recurring charges into over-estimating ROE.

The drawback seems to be that you have to go back into the mists of time to find out what the true retained earnings should be, and scrupulously adjust for capital issues, and suchlike. To make matters worse, you need a good set of accounts, which you can probably only get for 5 years. Sites might give you net income, but they wont give you comprehensive income – information which you need to see what’s been shifted around where.

JC: Well, once you are interested, you can always go back at least ten years with the SEC filings.  Also, watching margins, buybacks, prior use of capital allocation can give you a further clue. Also, how clean is their accounting? Track what management says vs. what they do.  You have to put together a mosaic on the company.

Also, what’s you view on goodwill? Should it be treated as a non-recurring charge?

JC: No, because some businesses like Cisco (CSCO) or Seacor (CHK) are making acquisitions as part of their ongoing operations. Better to understand the particular business rather than apply a one-size-fits all approach.

What about exceptionals that seem all-too-frequent? Would you treat them all as non-recurring, or might you assign a proportion as recurring, and a proportion as non-recurring? Maybe you could say a proportion of sales would count as non-recurring, and a proportion as recurring. Maybe you could take a proportion as recurring – say 20% – and the rest non-recurring. You could, of course, argue that over the long term, all exceptional items are recurring to a first order of approximation.

JC: I am a little lost on this question. Can you provide an actual example? In the end, you are trying to get to “normalized” earnings. What is the basic owner’s earnings (cash you can take out of the business without hurting the business in its competitive environment). Many businesses are too tough to figure out what their normalized earnings will be so you walk away. There is a reason why Buffett invests in a chewing gum company (Wrigleys) and not Microsoft. He wants to know where the business will be in ten years. People will still chew gum but will they still increase their use of Microsoft Office?  I am not implying that you not invest in Microsoft–just be ware of the risks in your assumptions.

JC: We will have a long, brutal slog in analyzing how to value growth in a few weeks. You have to know this as an investor, but the real fun is in understanding a business so you can have some confidence in your assumptions.

Thanks for the questions.