Return on Invested Capital (ROIC): Why High Returns Require More Than High ROIC
Why high returns require high ROIC and high growth, not high ROIC alone.
Executive Summary
Investors have been fascinated with return on invested capital (ROIC) and, in particular, seek to invest in businesses that can generate high ROICs. And for good reason, the higher the ROIC, the better the business. Yet, businesses with high ROICs alone are insufficient to generate strong long-term investment returns.
Warren Buffett says you can’t earn returns higher than a company’s ROIC. He is right and wrong. This incomplete and false understanding often leads unknowing investors to chase only high-ROIC companies, thinking they can achieve returns similar to those of the high-ROIC companies.
“The higher return a business can earn on its capital, the more cash it can produce, the more value is created. Over time, it is hard for investors to earn returns that are much higher than the underlying business’ return on invested capital.” Warren Buffett
We seek to explain why a company with a high ROIC would not necessarily deliver a similar high long-term total shareholder return.
In addition, businesses must be able to continue reinvesting capital at an attractive ROIC that allows them to grow revenue, earnings, and free cash flows strongly and compound for a long time.
It is not one or the other; it has to be both (unless the business’s valuation/price is really low). Unfortunately, there are very few companies that can do both, especially over a long period. When we find one, we seek to hold on to them for as long as we can.
What we really want to do is buy a competitively advantaged business that we think can earn a high return on invested capital and can reinvest a significant portion of its earnings back into the company at such high returns to build and grow value for a very long time. Over time, these compounding machines tend to generate higher returns and greater wealth for shareholders.
We seek to write a basic yet sufficiently comprehensive primer on value creation, what ROIC is, and when reinvestment and growth are good (which is what we want), and provide a practical framework for understanding a business's ROIC, reinvestment, and growth, and to tie it all back into investing and forward returns.
PART 1: FOUNDATIONS
What is ROIC & why it matters
How is value created
What is the cost of capital for companies
How to link value creation with ROIC, WACC & growth
How do a company’s business decisions drive long-term value creation
PART 2: THE REAL WORLD
What is the challenge of intangibles with ROIC
How much to pay for high vs low ROIC companies
Which industries tend to generate higher ROICs
What sustains a business with high ROIC
What competitive advantages can sustain high ROICs
How do ROICs tend to evolve over time
How do companies with high/low ROICs evolve over time
How do companies’ ROICs vary across business cycles
How many companies out there actually have high ROICs
PART 3: ROIC & RETURNS
What are the primary business strategies to achieve high ROIC
Why is the ability to reinvest at high ROIICs important
Why does earnings growth matter to investors
How do ROIC and reinvestment rates drive earnings growth
Why higher growth and higher ROIC drive higher value
What does higher ROIC and earnings growth mean for valuations
How do we link a company’s ROIC across its corporate lifecycle back to investing
PART 4: INVESTOR PLAYBOOK
Why does high ROIC not necessarily mean high returns
How does ROIC tie back to Free Cash Flows
How have higher and lower ROIC companies performed historically
Bringing it all together.
PART 1: FOUNDATIONS
Two timeless truths about value creation.
Companies thrive when they create economic value for their shareholders.
Companies create value by investing capital at rates of return that exceed their cost of capital.
What is ROIC?
Let’s start with the definition of Return on Invested Capital (“ROIC”). ROIC is essentially net operating profit after tax (NOPAT) divided by invested capital (IC).
ROIC is a measure of value creation. NOPAT is a business's cash earnings that exclude financing costs, meaning it is the same regardless of how a company chooses to finance itself —by equity or debt.
The denominator, invested capital, is equivalent to the net assets a company needs to run its business (operating) and how it finances those assets (financing).
There are two ways to calculate invested capital: either from the (1) asset or the (2) liability side of the balance sheet.
Because balance sheets balance, both approaches are equivalent.
How is value created?
Companies create value for their owners by investing cash now to generate more cash in the future. The amount of value they create is the difference between cash inflows and the cost of the investments made, adjusted for the time value of money and the riskiness of future cash flows.
Essentially, a business is only valuable if it can generate sufficient cash flows in the present and future that far outweigh the cost of capital paid throughout the periods.
The more cash flows it can generate, the more valuable the business. This is something that companies tend to have more control over.
The lower the cost of capital, the more valuable the business. However, the cost of capital (i.e., interest rates) fluctuates wildly over the long term (as we explain below), and companies tend to have far less control over it in the short term.
What is the cost of capital for companies?
Every company generally raises capital through two primary methods:
(1) Equity, which involves selling a portion of the company’s ownership to investors
(2) Debt, which involves borrowing money that must be repaid with interest
The cost of capital for businesses is the weighted average cost of capital (WACC), which is the weighted average of the cost of equity and the after-tax cost of debt.
Most companies (excluding financials and real estate) that raise debt typically do so through long-term, fixed-rate debt. As such, borrowing rates usually reflect a credit risk premium and a term premium relative to the prevailing benchmark interest rate. In general, the poorer the company’s ability to generate cash, the weaker its balance sheet, the longer the debt tenor, the higher the cost of borrowing, and vice versa.
Fluctuations in the prevailing benchmark interest rates affect only new incremental debt to be refinanced, not all existing debt. Thus, it becomes ridiculous to keep adjusting the cost of debt daily just because the benchmark interest rates (e.g., USD 10-year Treasury yields) are changing at the marginal rate.
Risk-free interest rates (e.g., USD 10-year Treasury yields) are cyclical and tend to follow market/business cycles, and typically exhibit a negative correlation with market returns and the equity risk premium (ERP), which is market returns less the risk-free rate. If you look at the historical chart of the US cost of equity, it has been range-bound between 6% and 10% over the last 30 years.
Interestingly, higher interest rates do not necessarily lead to a higher cost of equity or a higher WACC, as lower market returns and lower equity risk premiums often offset the effect, and vice versa. Similarly, it is silly for one to keep adjusting the cost of equity daily in response to changes in interest rates or market returns. It is far better to assume an average market-cycle rate that is approximately right than to be precisely wrong.
How to link value creation with ROIC, WACC & growth?
If ROIC exceeds WACC, value is created. But if ROIC is similar to WACC, no value is created. And if ROIC is lower than WACC, value is being destroyed. The more positive the spread between ROIC and WACC, the more value is being created. Vice versa, the more negative the spread, the more value is destroyed.
Not all growth creates value. The answer is that it depends on how profitable the business is and how high its ROIC is relative to its cost of capital. If ROIC exceeds WACC, growth increases value, and a company should reinvest.
But if ROIC is similar to WACC, growth creates no value. And if ROIC is lower than WACC, growth destroys value. The company is better off in both scenarios: not reinvesting and instead focusing on improving its ROIC.
Companies create value by earning a return on invested capital (ROIC) greater than the cost of capital. The more they can invest at returns above the cost of capital, the more value they create. Growth only creates more value as long as the ROIC exceeds the cost of capital.
If ROIC is at or below the cost of capital, growth will not create value. Instead, it will destroy value. Companies should aim to find the optimal long-term combination of growth and ROIC that drives the highest discounted value of their future cash flows.
How do a company’s business decisions drive long-term value creation?
Below is the self-explanatory flowchart that ties back to how much a company makes, its investing and financing decisions, and ultimately to ROIC and economic value added (EVA), to understand the long-term drivers of value creation.
A company’s revenue and expense decisions shape its operating profit, while investing decisions determine how much capital is deployed into working capital and capital assets. The magic happens when post-tax operating profit meets invested capital, producing ROIC. But ROIC alone does not tell the whole story.
Only when ROIC exceeds the weighted average cost of capital (shaped by financing decisions) does reinvestment and growth create positive economic value. In essence, every business decision of pricing, spending, investing, and financing flows into a single outcome. Is a business eventually earning more on its capital than it costs to obtain, and able to keep reinvesting that capital for faster growth? That is the difference between businesses that create and grow value and those that fail to do so.
PART 2: THE REAL WORLD
What is the challenge of intangibles with ROIC?
Before we dive deeper, we must address a critical measurement problem that affects nearly every modern business. The numbers we see on balance sheets are no longer accurate. Not intentionally, but accounting rules written for the industrial age struggle to capture value in the digital age.
This makes high-growth tech companies appear less profitable and more expensive than they actually are. If we do not understand and adjust for this distortion, we will systematically undervalue the best businesses of our era.
Here is what’s really happening...
The chart below shows the capital stock of US public companies from 1985 to 2020. Intangibles (e.g., intellectual property, brands, and networks) have been growing faster than tangibles (e.g., property, plant, and equipment) and are estimated to comprise 42% of the capital stock in 2020.
Tangible investments, which are physical, dominated in years past. Intangible investments, which are nonphysical, are much more prominent today. The rise of intangibles relative to tangibles over the past few decades is expected to continue strongly.
Capitalization is the accounting practice of recording a cost as an asset on the balance sheet and recognizing its cost over its useful life. Currently, all tangible and intangible assets, whether purchased or acquired via M&A, are capitalized on the balance sheet and expensed in the income statement over their useful lives.
However, internally generated intangibles are not capitalized and are immediately expensed on the income statement rather than recorded on the balance sheet and amortized over time. This is because accountants are uncertain about the sales that these investments may generate. So, to be conservative, they do not apply the matching principle of sales and expenses, and expense the outlays immediately. This causes near-term expenses to rise, profits to fall.
This significantly depresses near-term profitability, making companies that are spending a lot on intangibles seem less profitable than they really are and more expensive by conventional valuation metrics (e.g., price-to-book (PB) or price-earnings (PE) ratios), particularly when they are heavily reinvesting early on.
How much to pay for high vs low ROIC companies?
In general, as the chart below shows, higher-ROIC companies are valued at higher multiples of enterprise value (EV) per invested capital. Vice versa, the market tends to price lower-ROIC companies at much lower EV/invested capital multiples. Sometimes, seemingly “expensive” and “cheap” companies are priced as such for a reason, and it is crucial to zoom out and realize what you are buying. In short, high-ROIC companies tend to be expensive, and low-ROIC companies tend to be cheap.
Which industries tend to generate higher ROICs?
Below are the traditional and adjusted (for intangibles) ROICs for the 80th to 20th percentile by each industry of the Russell 3000 from 1990 to 2021, compiled by Michael J. Mauboussin.
The adjustment takes selling, general, and administrative (SG&A) expenses and reclassifies them as investments, increasing NOPAT and invested capital. While this reclassification does not affect free cash flow (FCF), the main driver of corporate value, the adjustment provides a more accurate return on capital.
What should be apparent from the second chart below is that the best companies in specific sectors (i.e., 80th percentile) tend to generate much higher ROICs. For example, looking at adjusted ROIC, the sectors are software, computer & peripherals, semiconductor equipment & products, IT consulting & services, communications & equipment, internet software & services, internet & catalog retail, biotechnology, and tobacco. Excluding biotechnology (outside our circle of competence) and tobacco (which does not align with our Vision Investing philosophy), these are also the sectors in which most of the companies that we tend to prefer and invest in.
What sustains a business with high ROIC?
Companies only create value when they (1) keep growing durably for an extended period of time, and (2) earn a return on capital that exceeds their cost of capital consistently.
For a company to keep growing fast, there must be a significant opportunity and a large total addressable market (TAM) to reinvest new capital at high returns relative to costs and to penetrate and gain market share. The faster they can grow, the greater the cash flows and value creation.
Conversely, competitive advantage is what sustains growth and high ROIC. Companies with attractive profitability will tend to attract new entrants seeking to compete profits away from the incumbents, causing ROICs to mean-revert.
A business with a wide moat and numerous competitive advantages in a highly monopolistic/duopolistic/oligopolistic market structure with strong unit economics tends to sustain higher ROIC durably over extended periods.
What competitive advantages can sustain high ROICs?
A company’s competitive advantages derive from a combination of ten sources, as outlined in the table below.
Of these, five (i.e., innovative products, quality, brand, customer lock in, rational price discipline) allow companies to charge a price premium, four (i.e., innovative business method, cornered resource, economies of scale, scalable product/process) contribute to cost and capital efficiency, and one (i.e., network effects) combines price and cost advantages to produce increasing returns to scale.
Businesses with the highest returns are often those that weave together multiple of these competitive advantages. The most significant potential for superior ROIC lies in increasing network effects (our preferred), which is difficult to achieve and rare.
How do ROICs tend to evolve over time?
Thus, it is not just about solely focusing on ROIC, but on how high ROIC is relative to the cost of capital, whether it is increasing, and whether it can be maintained at elevated levels.
The bottom line: ROICs tend to revert to the mean, primarily due to size, competition, and maturity. How long ROICs mean-revert, whether over quarters or decades, ultimately depends on the strength of a company’s competitive advantage.
The challenge is to find companies that can defy expectations by maintaining, or even improving, their ROICs. We must evaluate whether a business can sustainably and durably maximize its future economic profit rather than on ROIC alone.
How do companies with high/low ROICs evolve over time?
The chart below breaks down annual ROICs by quintiles (20% slices) and allows the universe to be reshuffled. It becomes clear that the best companies with superior ROICs tend to maintain them. Companies with poor ROICs tend to stay that way.
Because great companies tend to stay great, and lousy companies tend to remain awful, we must focus solely on the top companies with the highest ROICs, and those in which we have a high degree of confidence will likely get there.
As long as the company’s ROIC is not structurally declining during weaker times, we must have the temperament and patience to hold on to them, and as long as the thesis remains intact, even be willing to double down and invest more when they are beaten down, which often follows lower profitability from heavy reinvestments.
How do companies’ ROICs vary across business cycles?
The chart below shows the traditional and aggregate ROICs for the Russell 3000.
The ROIC path for most companies is far from linear and smooth sailing. ROICs, in aggregate, often zigzag with business cycles. Sometimes companies go through periods of heavy investment, and sometimes these taper off, allowing them to benefit from prior investments later on.
How many companies out there actually have high ROICs?
The chart below shows the distribution of ROICs for the Russell 3000 (3,000 of the largest US stocks by market capitalization), excluding the financial and real estate sectors, using traditional and adjusted ROICs.
Companies with the highest ROICs are more likely to generate strong economic profits, which, in turn, lead to stronger shareholder returns over time.
That is also why we prefer to focus on companies that either have (1) high ROICs we think can sustainably maintain, or companies with (2) rapidly improving ROICs that can be very strong.
Looking at the entire universe of over 55,000 publicly listed companies (primary securities), the distribution is even more pronounced and power law-driven than that of the Russell 3000.
Only a small percentage of the entire universe (55,321 companies) has very high ROICs: ~5.5% have >20% ROIC, ~3.6% have >25% ROIC, ~2.4% have >30% ROIC, and ~1.5% have >40% ROIC.
Only a tiny percentage of companies have high ROICs. Focus on the right tail.
PART 3: ROIC & RETURNS
What are the primary business strategies to achieve high ROIC?
High ROIC that exceeds the cost of capital reflects competitive success resulting from a company’s business strategy. Decomposing ROIC to understand a business’s strategy and how it generates returns can provide clues about its competitive advantage and help us assess its sustainability.
By adding sales to both the denominator of NOPAT and the numerator of invested capital, we can further break down ROIC into NOPAT margin and invested capital turnover. NOPAT margins measure profitability, and invested capital turnover measures capital efficiency. Sales cancel out when both terms are multiplied.
Companies can pursue two different generic business strategies to achieve the same high ROIC. Typically its either through (1) differentiation (bottom right) where a company is selling its goods or services at a premium to others with higher profitability with higher NOPAT margins but at significantly lower volumes and lower invested capital turnover, or through (2) cost leadership (upper left) selling its goods or services at a relatively lower price with lower profitability and lower NOPAT margins but at significantly higher volume and higher invested capital turnover.
The chart below plots the top 500 companies in the Russell 3000 (excluding financials and real estate) by their ROIC drivers: NOPAT margins and invested capital turnover. Retailers like Target, Walmart, and Home Depot (at the top left) operate at lower profitability but with much higher sales turnover.
Low profit margins do not necessarily mean poor businesses; if they can operate efficiently with higher turnover, they can still be high-ROIC businesses.
Conversely, service companies like Mastercard and Microsoft (at the bottom right) operate with higher profitability and lower sales turnover.
It is imperative to avoid the no-man ’s-land of low-ROIC, low-turnover companies.
Adjusting for intangibles leads to higher NOPAT and invested capital, and since sales remain unchanged, NOPAT margin rises while invested capital turnover declines. Directionally, the insights remain intact.
The best companies will have to choose between being differentiators and cost leaders to generate high ROICs. As investors, you should know which of the two primary business strategies the companies you own belong to.
Why is the ability to reinvest at high ROIICs important?
ROIC is a static snapshot in time. How ROIC changes over time matters as well. One should focus not just on the absolute ROIC, but also on return on incremental invested capital (ROIIC). Think of ROIC as stock, and ROIIC as flow. If incremental capital is reinvested at ROIICs that are even higher than high ROICs, it will drive ROICs higher over time, and vice versa.
ROIIC is the ratio of the change in NOPAT and the change in invested capital. Yet be aware that annual ROIIC calculations can be highly noisy and volatile, especially for businesses with volatile NOPAT and lumpy investments. Focus directionally on the longer-term trend instead.
Why does earnings growth matter to investors?
Revenue growth translating into earnings growth is the single most significant contributor to rising stock prices. If companies can keep growing earnings for years and decades, and if the stock market is not too exorbitantly expensive, one will likely still end up with a fine-looking result. Earnings are the weighing machine for stock prices over the long term. When you realize this, pretty much everything else is noise.
“In the short run, the market is a voting machine but in the long run it is a weighing machine.” - Benjamin Graham
For top performers, long-term revenue, earnings, and free cash flow growth are the most important long-term drivers of shareholder returns for companies with high returns on capital (i.e., 95% for 10-year total shareholder returns).
Notably, companies with negative working capital have lower invested capital and, accordingly, tend to have higher ROICs. Very few companies have negative working capital, and we tend to prefer those that do.
How do ROIC and reinvestment rates drive earnings growth?
The reinvestment rate measures the percentage of earnings that a company plows back into the business every year (i.e., reinvestment / net income).
ROIC measures the return the company makes on these reinvested earnings.
Let’s go through three scenarios with varying earnings growth, reinvestment rates, and ROICs, and hopefully by the end, you will begin to appreciate the importance of companies with high ROICs and their ability to reinvest.
Scenario 1: The Higher the ROIC, the lower the Reinvestment Rate
High ROICs are great because that means that a company does not need to invest a lot of its earnings back into the business for earnings to grow fast, and it has the flexibility to use the excess earnings to repay debt, buy back stock, pay dividends, make acquisitions, or do nothing with them. Conversely, low-ROIC companies need to reinvest more capital to achieve the same growth.
Scenario 2: For the same Reinvestment Rate, the higher the ROIC, the higher the Earnings Growth
Higher ROICs at the same reinvestment rate allow companies to drive even faster earnings growth, which ultimately leads to more value creation over time and, correspondingly, higher valuations and higher returns.
Scenario 3: For the same ROIC, the higher the Reinvestment Rate, the higher the Earnings Growth
For the same ROIC, if a company lacks sufficient reinvestment opportunities and can only reinvest at lower rates, it will grow earnings more slowly. The shareholder return would then approximately be the sum of (1) earnings growth, (2) the earnings yield (i.e., earnings/price), and (3) any change in PE valuation multiples, and if the company is expensive (i.e., high valuation multiples), then the prospective returns are likely to be even poorer.
That’s why, if an investor’s strategy is to buy more mature “high ROIC” companies at the top of a company’s growth S-curve with little reinvestment opportunities and low single-digit organic growth, the price at which we buy these companies matters more.
Conversely, suppose an investor’s strategy is to buy faster-growing “high/rapidly improving ROIC” that can sustain their high ROICs, and are still in the early innings of their S-curve, and have plenty of runway to keep reinvesting for decades and grow earnings durably. In that case, the price matters less, as earnings growth would likely drive most of the future returns.
Why higher growth and higher ROIC drive higher value?
Assuming a WACC of 10% and starting NOPAT of $100m, it becomes clear in the chart below that (1) for the same growth rate, higher ROICs drive higher value, and (2) for the same ROIC, higher growth drives higher value. It is not either or, but both.
What does higher ROIC and earnings growth mean for valuations?
It is silly for investors to say one company is “expensive” or “cheap” based on absolute or relative valuation multiples alone (e.g., price-earnings, EV/FCF, etc.) without considering how profitable they are, ROIC-wise, and how high their earnings growth is (via reinvestment rates). Trying to do so is foolishly comparing apples to bananas.
Using a simple perpetuity formula (see derivation below) of assuming the same earnings growth and ROIC into perpetuity, it becomes evident that the higher the ROIC and earnings growth, the higher the PE valuation multiple should be.
Vice versa, the lower the ROIC and earnings growth, the lower the PE valuation multiple should be. Both ROIC and earnings growth determine whether a company should trade at higher or lower valuation multiples.
The market pays for growth only when ROIC exceeds WACC and when there are strong reinvestment and growth opportunities.
PE valuation multiples increase for higher ROICs alongside higher earnings growth. This is because the ability to reinvest at high ROIC drives greater value creation, making the companies even more valuable.
Conversely, when ROIC equals the cost of capital at 9.5%, earnings growth neither creates nor destroys value, and the PE valuation multiple remains unchanged at 10.5.
Even worse, when the ROIC is 8.5% or lower than the cost of capital at 9.5%, choosing to reinvest more and grow faster will quickly destroy value, making the company worth less and leading to a decline in PE valuation multiples.
How do we link a company’s ROIC across its corporate lifecycle back to investing?
It is crucial to continually assess a company's life cycle to determine whether it (1) can maintain strong ROICs and (2) has sufficient opportunities to reinvest capital to grow.
As a company moves from the growth phase to the mature phase, the attractiveness of investing new capital declines. It gradually finds lower and declining ROIICs for new incremental capital. Investing more capital at ROIICs below the current ROIC will only further pressure ROICs downward over time.
In this case, the company will be better off reinvesting much less to maintain its high ROICs, which then leads to rapidly decelerating revenue growth.
Typically, when a business chooses to start returning huge swaths of capital to shareholders through dividends or share buybacks, it generally implies that it sees fewer attractive opportunities to reinvest in the business than before, highlighting signs of a company’s lifecycle maturity.
Low revenue and earnings growth likely translate into low price returns for investors over time, and a much larger share of total shareholder returns will come from the price paid (i.e., the earnings yield) rather than from earnings. In such a scenario, the price paid has to be reasonable and sufficiently attractive.
For example, if a high-ROIC 20% company now grows revenues/earnings at 5% and trades at a 25x PE (i.e., a 4% earnings yield), the long-term returns are unlikely to be significantly different from ~9% p.a. (i.e., 5% p.a. + 4% p.a.).
What becomes clearer is that overpaying for mature, slower-growing, high-ROIC companies would likely be much more disastrous than “overpaying” for younger, faster-growing, improving, or high-ROIC companies with a long growth runway. The latter is what we prefer to focus on rather than the former.
PART 4: INVESTOR PLAYBOOK
Why does high ROIC not necessarily mean high returns?
There is a common misconception that if you own a high-ROIC business for a long time, you will earn returns similar to its ROIC. This often leads investors to chase only high-ROIC companies, without considering reinvestment opportunities/rates and earnings growth.
The popular quote below by Charlie Munger talks about this.
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”
- Charlie Munger
A stock would likely earn returns similar to its ROIC only if it continues to have the opportunity to keep reinvesting most of its capital at high ROICs.
Conversely, if a company has high ROIC, is a more mature business, closer to the top of its S-curve, and has slower growth (i.e., <5%) due to limited opportunities to reinvest its capital at high returns, it would likely have to return most of the excess earnings to shareholders.
The prevailing stock valuation at which these earnings come back to shareholders matters much more to shareholder returns than the high ROIC itself.
High returns need high ROIC + high reinvestment. It’s not ‘or,’ it’s ‘and.
Suppose a 19.5% ROIC company is unable to reinvest any capital and does not grow earnings. Assume it trades at a 15x PE (assuming no change in valuation multiples), if the company chooses to return 100% of that capital via share buybacks or dividends, it would be an implied 6.7% (1/15) earnings yield that the shareholder will effectively indirectly receive via buybacks/dividends/higher enterprise value, and adding the 0% earnings growth, would render a significantly lower combined total shareholder return of 6.7% as compared to the company’s much higher ROIC of 19.5%.
Whereas if this 19.5% ROIC company reinvests more of its earnings to achieve higher earnings growth, its total shareholder returns tend to converge to the higher combination of its earnings growth and its earnings yield (assuming no change in PE valuation multiples). The math is counterintuitive. The implications are profound.
Notably, the price (i.e., PE ratio) matters much more when earnings are growing much more slowly, and matters less when earnings are growing much faster.
High ROIC alone, without reinvestment opportunity (and growth), limits returns.
High ROIC is necessary but not sufficient. The best investments combine high returns on capital with abundant opportunities to reinvest at those high returns. ROIC without reinvestment is like having a Ferrari without a road. The potential is there, but you cannot compound it.
The below ROIC and Reinvestment matrix sums this up best:
How does ROIC tie back to Free Cash Flows?
The concepts of free cash flows, ROIC, and economic profits have common roots.
Free cash flow (FCF) is the cash a company can distribute to its claimholders, equal to NOPAT minus investment (versus the more commonly used cash flow from operating activities minus capital expenditures). Free cash flows should be adjusted for stock-based compensation, financing costs, and lease-related investments.
ROIC is NOPAT divided by invested capital, a measure of cumulative net investment. Economic profit is ROIC minus WACC times invested capital and measures a company’s residual income after considering the cost of capital.
A discounted cash flow (DCF) model based on either (1) free cash flow (FCF) or (2) economic profit (with ROIC, WACC, and NOPAT) will yield the same answer if the inputs are the same and the analysis is conducted correctly (see example below). Mathematically, companies with higher ROIC will generate more free cash flows per dollar of earnings.
How have higher and lower ROIC companies performed historically?
Below are two charts (while dated) that show that, historically, companies with higher ROICs tend to deliver stronger returns, while companies with lower ROICs tend to deliver poorer returns. Excellence compounds. Mediocrity multiplies.
Bringing it all together.
Understand the basics of value creation. Free cash flows are inextricably linked to ROIC. Focus on finding companies that are top dogs riding secular tailwinds with large total addressable markets (TAMs) operating in industry market structures servicing that tend to become more monopolistic/oligopolistic in nature that typically result in winners take all/most outcomes, that have strong and multiple competitive advantages (including network effects), providing products and services that customers love and want to keep using, and are willing to pay more for, coupled with strong profitability and unit economics, run by solid stratgic long-term focused management, backed by solid balance sheets, negative working capital, leading to high or increasing ROIC, providing strong opportunities to keep reinvesting to grow revenues, earnings, and free cash flows strongly over time, creating value, and in doing so compounding for long periods of time.
As investors who seek long-term outperformance, we have to continue to find these compounders early, buy them (even when they might seem “expensive” by conventional measures), hold them (through all the ups and downs), and even add to them (during the downs).
Excellence. Find excellence, buy excellence, hold excellence, add to excellence, and sell mediocrity. That’s how we invest.
It is not rocket science. But you need a solid psychological and behavioral mindset to hold them through both the good and tough times, through the highs and lows. It is pretty much all that matters for long-term market-beating returns.
Reference Materials
The End of Accounting and the Path Forward for Investors and Managers, 1st Edition - Baruch Lev and Feng Gu (2016)
Valuation: Measuring and Managing the Value of Companies, University Edition (Wiley Finance) 8th Edition - Tim Koller, Marc Goedhart, David Wessels, McKinsey & Company Inc.
The Equity “Compounders:” The Value of Compounding in an Uncertain World (2016) - Bruno Paulson and Christian Derold
Investing in the Intangible Economy (Oct 2020) - Kai Wu, Sparkline Capital
Why Return on Invested Capital Is the Most Important Investing Metric (May 2022) - John Rotonti
Return on Invested Capital: How to Calculate ROIC and Handle Common Issues (Oct 2022) - Michael J. Mauboussin and Dan Callahan. CFA
ROIC and Intangible Assets: A Look at How Adjustments for Intangibles Affect ROIC (Nov 2022) - Michael J. Mauboussin and Dan Callahan. CFA
Capital Allocation: Results, Analysis, and Assessment (Dec 2022) - Michael J. Mauboussin and Dan Callahan. CFA
ROIC and the Investment Process: ROICs, How They Change, and Shareholder Returns (Jun 2023) - Michael J. Mauboussin and Dan Callahan. CFA
Total Shareholder Return: Linking The Drivers of Total Returns to Fundamentals (Oct 2023) - Michael J. Mauboussin and Dan Callahan. CFA
Capital Allocation (Nov 2025) - Michael J. Mauboussin and Dan Callahan. CFA
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2 Nov 2025 | Eugene Ng | Vision Capital Fund | eugene.ng@visioncapitalfund.co
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Very insightful, appreciate all the work that went into this