A company with a high ROIC has the potential to reinvest its profits and grow its business, leading to long-term growth in earnings and potentially higher returns for investors.
What is ROIC and why investors should pay attention to it? In this article, I will share our insights about why we seek companies with high ROIC.
Return on Invested Capital (ROIC) in a nutshell
A ROIC of 20% means that for every euro invested in the company’s operations, the company generates 0.20€ in after-tax profit. So, if the company invests 100€ in its operations, it will generate 20€ in after-tax profit (100€ * 0.20 = 20€).
Having a sustainable ROIC of 20% over multiple years has a positive impact on a company’s future cash flows and market value.
This is because a higher ROIC indicates that a company is using its capital efficiently to generate profits and higher returns for investors in the future. The market value of a company is often driven by its expected future cash flows, so a higher ROIC can lead to a higher valuation.
What a high ROIC tells about a company?
A high Return on Invested Capital (ROIC) can indicate a number of positive things about a company:
- Efficient use of capital: A high ROIC indicates that a company is effectively using its capital to generate returns. This suggests that the company is investing in profitable projects and has a strong ability to generate returns from its investments.
- Strong competitive position: Companies with high ROIC often have a strong competitive position in their industry, as they are able to generate higher returns on invested capital than their competitors. This can indicate a sustainable competitive advantage and a strong ability to generate profits in the long term.
- Growth Potential: A company with a high ROIC has the potential to reinvest its profits and grow its business, leading to long-term growth in earnings and potentially higher returns for investors.
- Attractive investment opportunity: Companies with high ROIC may be attractive investment opportunities, as they are able to generate high returns on capital. This can make them a desirable investment for investors seeking to maximize their returns.
However, it’s important to note that high ROIC is not always a sign of a company’s financial strength. Other factors, business model, and the overall financial health of a company should also be considered when evaluating the significance of a high ROIC.
More importantly, there are larger differences in capital requirements between industries. Software companies don’t invest in large factories. Their capital may not be found on the balance sheet e.g., human capital, IP, trade secrets, or brand.
What can be considered a good ROIC?
There is no set “good” ROIC percentage as it varies greatly based on the industry and other factors. However, a ROIC of 10% or higher is generally considered strong. In any case, a company’s ROIC must be higher than its WACC (Weighted Average Cost of Capital). Otherwise, a company is losing its capital to poor investments.
3 different examples from the Sifter portfolio
Sifter Fund’s average company has 21% ROIC. The ROIC measures the amount of return a company generates for each euro of capital invested in its operations. In the table, we can see how a high ROIC correlates with a growing net profit in four years’ time (2018-2022).
| ROIC | Profit growth | Share price % | |
|---|---|---|---|
| NOVO NORDISK A/S-B | 60 % | 145 % | 255 % |
| APPLIED MATERIALS INC | 37 % | 152 % | 108 % |
| OLD DOMINION FREIGHT LINE | 33 % | 227 % | 277 % |
Source: Bloomberg
Novo Nordisk, a Danish pharma company, is a typical example of how efficiently a company is using its capital to generate profits. The net profit after taxes has grown 145% in four years and the average ROIC in 2018-2022 is 60%.
Applied Materials, a semiconductor equipment manufacturing company, business is capital intensive business. Nevertheless, the company has invested wisely and is able to accelerate its profit by 152% in 2018-2022 with a 37% average ROIC.
Old Dominion Freight Line is a leading trucking company focusing on less-than-truck-load transportation. Its superior business model and smart investments in business expansions have not only generated a high ROIC (33%) but also 227% profit growth in 2018-2022.
Image © Novo Nordisk
Sifter Fund’s customer promise
Sifter is an investment fund that invests in quality businesses with strong competitive advantages.
The fund aims to provide high returns by allocating its portfolio globally to only the highest-quality companies.
With a 20-year track record, Sifter has delivered an average annual net return of 9.1 percent to its investors, demonstrating the success of its focus on quality and proven investment process.
To deepen your understanding of our investment strategy, be sure to check out our guide on Long-Term Quality Investing for an in-depth look at our approach to quality investing.
Santeri Korpinen
CEO, Sifter Capital
