Thread by @heymaxkoh

Return on Incremental Invested Capital (ROIIC)

You can be a better investor than 99% of others simply by understanding this.

I will explain it using an orange juice analogy.

And you will NOT need to calculate a single number in your head:

Before I begin:

Know that I won't be covering how to calculate this.

There are many other great threads and articles online that teach you how to do that.

I'll link to some of them at the bottom.

Instead, I will explain using an analogy of how ROIIC works.

Let's go:

Imagine you own a business that is selling orange juice in the middle of the desert.

Every year the desert only gets a fixed number of travellers coming through.

So the money you spend to setup your orange juice stand and buy the oranges...

That's called "Invested Capital"

And assume every year without fail...

You generate profits from your orange juice operation.

These profits can be paid out to shareholders of your juice operation...

Or you can plough it back to the business to expand.

There is a problem here though...

Your desert only gets a fixed number of travellers per year and you're already serving them all.

And you're also a lazy bum.

You don't plan on expanding into other deserts nearby.

So even though you are making profits...

there is no where else for you to re-invest the additional capital.

So your business will continue generating a consistent return on your original invested capital each year.

But with ZERO places for reinvestment.

Whereas another business who plans to expand into other deserts nearby...

They will put the money back into the business.

And so the invested capital increases as they keep re-investing profits back in.

But the profits also continue to get fatter as the business expands.

In summary, Return on Incremental Invested Capital (ROIIC)

It's simply a combination of:

• how much money a company can generate from the capital it puts into the business

• how much of that money is reinvested back into the business to generate similar returns.

So why is this important?

Even if you have no plans to calculate this...

Just understanding ROIIC will make you a better investor than 99% of market participants who only look at the stock price.

Here's 5 reasons why:

1. Forces you to think of business opportunities and market size

For a business to re-invest capital back in, it should have ample opportunities on the horizon.

This also means it needs to be in a huge market.

So thinking of reinvestment forces you to consider these.

2. Management capital allocation ability

A business's return on capital is all down to its management decisions.

Do they have the ability to allocate capital wisely...

Such that it can generate decent returns for you as an owner?

Thinking of ROIIC forces you to consider this.

3. Is the business asset light or heavy?

Thinking of ROIIC forces you to consider if the business needs a lot of capital to operate.

Example: a software biz will need less capital than a steel manufacturing plant.

So this helps you understand its ability to scale fast or slow.

4. Forces you to consider the business moats

A busines can generate a high return on its capital today.

But if its in a competitive space with low barriers, then more players will enter.

Overtime, this will drive down profits and affect its return.

4b. Thus keeping ROIIC in mind makes you think about a business' competitive advantages.

It helps you think like a real owner who owns part of the company.

Instead of just a person holding a stock ticker.

It makes you grounded.

5. Even if the company has negative earnings, this framework is still useful

For many tech and high growth companies, you can't calculate ROIIC.

Because they may have negative earnings and also cashflow due to reinvesting heavily back to the business.

5b. But having this in mind still forces you to think like an owner.

It pushes you to think of all the reasons stated above.

Is the business building its advantage such that it can be profitable in future?

Is management allocating capital to the best opportunities?

5c. These are all useful questions to ask as an owner of a company.

Even if it's now burning cash to grow the business rapidly...

Thinking about ROIIC pushes you to think like an owner.

And that's how you keep a long term mindset and stay grounded as an investor.

If you find this helpful, then follow me at @heymaxkoh

I tweet about my journey of how I attained financial freedom before 30...

Simply by investing in great businesses.

Also check out this thread on how to endure stock market volatility like a boss:

https://twitter.com/heymaxkoh/status/1448657177938325513?s=20

How to calculate ROIIC:

Here's an article by @JohnHuber72 on his blog that explains it in detail

sabercapitalmgt.com/calculating-th…

Here's another one by @HaydenCapital breaking it down too:

haydencapital.com/wp-content/upl…