Understanding Compounding: The Importance of ROIC

“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 BuffettWhat is ROIC?When we buy a business intending to hold it for the long term, we are looking for a company that will compound and grows our equity value. A business will grow as long as it has the potential to generate cash flows in the future.Here we can trace the distinction between a “growth” and “value” stock. Shortly, growth has the majority of its present value derived from future cash flows. Value has the majority of its value-priced in the present, by its current fundamentals.Growth investors aim to buy businesses with unlimited upside, with lots of optionality and possibilities of accelerating growth (growing more and/or longer than what the market expects).Value investors focus on mispriced companies (e.g., businesses where the fundamentals, discounted by some valuation technique, point to a much more valuable business than what the market is pricing in).“What we really want to do is buy a business that’s a great business, which means that business is going to earn a high return on capital employed for a very long period of time, and where we think the management will treat us right.” Warren BuffettThese definitions can be confusing, and some investors are skeptical of them. One apparent reason is that if you stress the purposes, growth investors are also looking for devalued businesses. The difference comes from the fact that one group is trying to evaluate the future. The other is focusing more on the present (and discounted heavily in the future).Whatever the investor category you fit in, if you invest (and investing…