This Metric Made Buffet & Munger Billionaires - Here’s How To Use It

December 29, 2017

This Metric Made Buffet & Munger Billionaires – Here’s How To Use It

  • Return on invested capital is an interesting metric, one strongly promoted by Buffett and Munger.
  • I’ll show how to calculate and the impact it has on investment returns.
  • It’s very helpful to those who invest for the long term.



Introduction

Charlie Munger is known for his view of the investing world that has one advantage over all other views, it works and he has a 50-year track record with a 19% annual return to back up his statements. His view on investing is simple and can be synthesized by the following quote:

“It’s obvious that if a company generates high returns on capital and reinvests at high returns, it will do well. But this wouldn’t sell books, so there’s a lot of twaddle and fuzzy concepts that have been introduced that don’t add much.”

Therefore, we have to see how to calculate returns on investing capital and how to use such a powerful tool when investing.

Return On Invested Capital (ROIC)

Return on invested capital shows how well a company is using its available capital. It’s calculated by using the following formula:

ROIC = net income / capital (equity plus long and short-term debt)

You’ll see many versions of this formula where some exclude taxes and interest expenses from net income, or goodwill, excess cash, etc.  from capital, but I find the above a very simple formula to use and also a conservative one that can help in identifying intrinsic value and a margin of safety.

I’ll calculate ROIC for two companies which, in comparison, will give an excellent basis for discussion, Southern Company (NYSE: SO) and Apple (NASDAQ: AAPL).

For net income, I will take the average net income over the past 5 years as often one-off items can skew current metrics. The debt and equity are derived from the balance sheet. I will make no adjustments as it keeps the calculation conservative.

Table 1: SO’s return on invested capital. Source: Author’s calculations.

SO’s return on invested capital is extremely low at 2.18%. Let’s compare SO’s return to Apple’s return.

Table 2: AAPL’s return on invested capital. Source: Author’s calculations.



Apple’s ROIC is almost 10 times better than SO’s which according to Charlie Munger, will result in a similar long-term return on investment. Munger might not be far from the truth as AAPL’s returns have been close to a 20% average return in the past 10 years while SO’s have been closer to 2%.

Figure 1: AAPL’s versus SO’s performance in the last 10 years. Source: Yahoo Finance.

Therefore, ROIC is an excellent metric to use when comparing investments. All other metrics fade in the long term as a company that manages to compound its capital at a high return rate will definitely do well over time. Charlie Munger states that over the very long term, the return on capital is what determines the return the stock will offer no matter the current discount.

Of course, there is a difference in the return if you bought AAPL in 2008 at $28.3 or in 2009 at $12.9, but the 2009 crisis is really a one of a kind event and even those who bought in 2008 at a huge premium in comparison to 2009 have achieved amazing returns.

Figure 2: AAPL’s stock price in the last 10 years. Source: Yahoo Finance.



Investors who bought AAPL in 2008 would have increased their capital 6 times while those who bough in 2009 would have increased their capital 14 times. Both are great results and show the importance of the ROIC measure.

Using the ROIC tool for assessing investments implies two things. One is a long-term view on investing and the second is that you compare many investments to find the best one. The long-term view allows the investor to disregard temporary market sentiment as timing the market is impossible. However, a high ROIC provides the necessary security that a permanent loss of capital is unlikely.

Of course, if there is the possibility to buy a wonderful business at a discount to its intrinsic value determined by its ROIC metrics, even better. However, as holding cash has a cost and market timing is impossible to do, when you find a business that has a strong return on invested capital in comparison to other businesses and is fairly priced and the high return is sustainable thanks to a strong moat, you might want to invest in such a business. If the business remains the same but the stock price drops, just buy more.

Such a strategy has made both Buffett and Munger billionaires, it might make you at least a millionaire if not better.

From a broader perspective, ROIC is another metric to use when analyzing a company. However, it’s one that deserves a significant weight in your decision-making process.



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