Updated 5/1/2024

“Leaving the question of price aside, the best business to own is one that can employ large amounts of incremental capital over an extended period at very high rates of return.”

Warren Buffett, 1992 Berkshire Hathaway Shareholder Letter

Return on Invested Capital is a metric I have been thinking about lately. The list of metrics that I include in my investment checklist is long: revenue growth, operating margins, payout ratios, free cash flow, return ratios, etc.

But if there was one metric that could tell me what is up with the company or that I could judge the quality by, it is ROIC.

All good businesses generate high returns on capital, and they do so regularly.

ROIC is important because it is a big driver of valuation. Businesses that generate higher returns on capital can invest less back into the business, and they have the additional free cash flow to return to the shareholders.

As we have learned in discounted cash flow valuations, a business’s value reflects the present value of its cash flows.

In today’s post, we will discuss:

• Warren Buffett’s Path to High ROIC
• Buffett’s First Category of ROIC for Businesses
• Buffett’s Second Category of ROIC for Businesses
• Buffett’s Third Category of ROIC for Businesses
• Resources for Learning More About ROIC

Warren Buffett’s Path to High ROIC

Buffett believes there are two main paths to high ROIC.

He believes that companies that produce high returns on capital do so by earning above-average profits or by quickly turning over their capital.

We can express Buffett’s idea by the Dupont formula, which is essentially:

ROIC = Earnings/Sales x Sales/Capital

Companies derive high returns on capital from either high profit margins (consumer advantages) or efficiencies on the production side (high capital turnover).

Some companies, like Visa, have extremely high profit margins. Visa has a built-in valuable two-sided network that offers low costs for each new user, allowing Visa to extract extra value from each user directly.

Or take Facebook, which has a two-sided advantage as well, by charging users nothing to use their platform and allowing them to collect high-margin revenues from the advertisers that want to sell to those customers.

Some companies have the advantage of being the only game in town. Think of Walmart during the last few months of stay-at-home orders. They were the only game in town for grocery shopping, for example. This allowed them to grow their profit margins during that period, which in turn allowed the company to grow its earnings at a faster clip than in the past.

Another example is the “toll road” Buffett often refers to in his letters. Verisign is a great example of a company you plainly can’t work around. Who is Verisign, you ask? Well, they are the toll road of the internet because you literally can’t dial up any website without a dot com. They own the suffix that comes after any domain name. If you own a domain with a .com at the end, you pay Verisign every year.

The Importance of a Strong Brand Name

Of course, a strong brand name is the strongest advantage out there.

Companies come in two flavors when it comes to big brand names. Think:

• A company that offers a superior product or service compared to the competition.
• A company that offers a product or service similar to competitors but tells a superior story about their product.

Great examples of the first brand characteristic would be Apple or Google.

Great examples of the second characteristic are Coke, Nike, McDonald’s, and Tiffany’s, to name just a few.

Most brands fall into the second category. Nike is the perfect example of a company that makes good shoes, but its shoes aren’t drastically better than those of its competitors. Michael Jordan would still be Jordan, even if he wore Addidas.

However, Nike excels because Phil Knight excelled at telling a better story than his competitors and then getting athletes like Michael Jordan to help push the narrative.

Buffett knows the power of a strong brand. Look at his portfolio. It is full of strong brands: See’s Candies, GEICO, Coke, American Express, Gilette, and Apple.

Buffett learned that beating his competition was not always about having a better product but about being able to tell a better story. See’s Candies didn’t have the best chocolate in the world, but they did a better job at marketing than their competitors, which allowed them to thrive.

That increased brand presence allowed See’s to strengthen the brand to the point that they could raise prices, which in turn increased the company’s profit margins.

All of this helped See’s grow its returns on capital. By increasing the profit margins, it was able to grow the business’s earnings without having to invest more capital.

Thus, the strength of the brand of See’s and the importance of a high ROIC.

Buffett’s First Category of ROIC for Businesses

I have been working my way through Buffett’s Letters to Shareholders, which has been a fantastic enterprise. I have learned so much. Luckily for you, I am going to share some of those learnings for those of you who haven’t read through the letters.

In the 2007 Letter referenced above, Buffett illustrates his thoughts on three categories of ROIC (Return on Invested Capital) for businesses. Let’s look at his thoughts on the first category:

According to Buffett, companies fall into three categories:

1. High ROIC Businesses with Low Capital Requirements
2. Businesses that Require Capital to Grow Produce Adequate Returns on that Capital
3. Businesses that Require Capital but Generates Low Returns

High ROIC Businesses with Low Capital Requirements

“Long-term competitive advantage in a stable industry is what we seek in a business. Suppose that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings.

At See’s, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See’s sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See’s family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire. 

We bought See’s for $25 million when its sales were $30 million, and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories. 

Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime, pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to “be fruitful and multiply” is one we take seriously at Berkshire.)”

I will make a few comments, but I thought the clips from his letter says it much more eloquently than I ever could.

When contemplating investing in a company, it is helpful to consider how much earnings the company can retain and reinvest. And what those reinvestment returns will look like into the future.

Let’s think about capital-light companies for a moment. A few that spring to mind are Visa (V) and Facebook (FB). Technology companies fall into the category of capital-light companies because once they achieve economies of scale, then increasing revenues and returns are far less costly for those companies.

Visa is growing at incredible rates without having to use much capital, partly because of the great network it has established and its market share and position in that market.

Facebook is in a similar situation because of the network and the ability to expand its user base, which costs them almost nothing. It needs to translate the platform into French to expand into a country like France. If Walmart wants to expand into France, it needs to build stores, create distribution networks, and hire and train employees to work in those stores, all of which are far more capital-intensive.

Buffett’s Second Category of ROIC for Businesses

Up next is Buffett’s second category for ROIC for businesses.

Businesses that require capital to grow produce adequate returns on capital.

“There aren’t many Sees in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments. 

A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google. 

One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure.

Nevertheless, this business requires a significant reinvestment of earnings if it is to grow. When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our purchase, depreciation charges have totaled $923 million. But capital expenditures have totaled $1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.) Our fixed assets, after depreciation, now amount to $1.079 billion. Pre-tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That gain gave us a good, but far from See’ s-like, return on our incremental investment of $509 million. 

Consequently, if measured only by economic returns, FlightSafety is an excellent but not extraordinary business. Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn considerably more money in this business ten years from now, but we will invest many billions to make it.”

Buffett is referencing Walmart as a great example of a company like this. For instance, Walmart’s current ROIC on a trailing twelve-month basis is 8.56, which on the surface doesn’t seem all that impressive when you compare it to Apple or Intel, which hover in the 25 to 30 range.

But of greater importance is the comparison of ROIC to something that is a component of the formula, which is the WACC (weighted average cost of capital), which in part measures how much the cost of debt and capital to finance the company’s assets.

At this point, please don’t get bogged down in the minutiae of the formulas and what they all mean. Instead, keep this point in mind: the bigger the difference between the ROIC and the WACC or cost of capital, the bigger the company’s ability to grow.

If you are curious about WACC and would like to learn more, please follow this link:

Weighted Average Cost of Capital Guide ( +WACC Calculator)

Going back to Walmart, the current ROIC is 8.56, and the WACC is 3.16, which is a nice range for a defensive company like Walmart. That little tidbit tells us that Walmart has plenty of life left to grow, and the investment in the company will bear fruit along the way.

The price we pay matters, but the returns you generate for that price matter, too; that is why focusing on a metric like ROIC can help you find companies that will grow your investments.

The first two posts are beginner-level, while Andrew’s last two are more “inside baseball” but written in a very approachable way.

Buffett’s Third Category of ROIC for Businesses

According to Buffett, companies fall into three categories:

1. High ROIC Businesses with Low Capital Requirements

2. Businesses that Require Capital to Grow Produce Adequate Returns on that Capital

1. Businesses that Require Capital but Generates Low Returns

Buffett references his disdain for airlines throughout his shareholder letters, and nowhere is it more evident in the following quote from his 2007 Shareholder Letter:

“Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.

The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice.”

Brutal, huh? It makes you wonder why he invested in airlines just recently and then bailed just as quickly. But I digress.

Later in the letter, he sums up the best way to think about these different categories:

“To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.”

 Another great example of this is Tesla, the company is “making” money now, barely, with government grants and tax credits for income.

Aside from the accounting trickery, Tesla is a company that requires tremendous amounts of capital to survive, either from debt or from shareholders in the form of share dilutions, which the company has been doing at a tremendous clip.

But the fact remains that Tesla is a car company that needs to build plants and bend metal to produce the cars. Despite its reputation as a tech company, it is still quite capital-intensive and will require that capital to grow into those valuations.

Tesla brings up another important point: the price you pay matters, and the price for Tesla currently is pricing all those cars and plants already being built and sold, but the fact remains that it will require billions to produce those vehicles.

Tesla is a lightning rod for investors, and I don’t mean to bash the investors who buy the company, but those who do are ignoring the tenets that Buffett is trying to teach us: ROIC is extremely important, and if we choose to ignore those basic lessons for the excitement of a stock price skyrocketing, then at some point you will get burned.

The longer-term better bet is to seek out businesses that can retain and reinvest large portions of their cash flow at high rates of return.

Those are the diamonds we look for: companies that can grow without large amounts of capital to sustain them. I think the savings account analogy Buffett uses above is the perfect illustration.

Resources for Return on Invested Capital

If this topic interests you but you aren’t sure where to turn, I am going to share some additional resources to help you along. Andrew has written some great posts recently on this extremely important topic, plus a few that are more beginner-level for those just starting.

Everything to Know about ROIC, with Average ROIC by Industry Data

Using Return on Invested Capital (ROIC) to Evaluate Stocks

How to Calculate Invested Capital for ROIC (the right way)

How to Calculate NOPLAT for Operating ROIC

The first two posts are beginner-level, while Andrew’s last two are more “inside baseball” but written in a very approachable way.

Final Thoughts

Return on Invested Capital is arguably one of the most important metrics to consider when analyzing a company. The company’s ability to reinvest in the company efficiently goes a long way toward the success of the company.

As Buffett so eloquently points out in his shareholder letters, finding companies that can reinvest their earnings back into the business so that they can grow without outside capital is the diamond we all look for, regardless of the industry.

Most investors have associated these types of businesses with today’s high-flying tech companies, such as Amazon, Google, Apple, Microsoft, and so on.

However, this concept applies to other types of businesses, and I would argue that these concepts are just as viable now as they were twenty years ago. Besides the high ROIC, the bigger consideration is the relationship to WACC or the discount rate you use to value the company. The bigger the gap between the two, the more potential for growth of the company, and that is, in the long run, what we want.

That is going to wrap up our discussion for today.

As always, thank you for taking the time to read this post, and I hope you find something of value on your investing journey.

If I can further assist, please don’t hesitate to reach out.

Until next time, take care and be safe out there,

Dave