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HomeInvestmentPower Of Reinvestment And Incremental ROCE

Power Of Reinvestment And Incremental ROCE

The first category comprises businesses that require minimal capital to expand. They possess inherent mechanisms that enable them to grow up to a certain point without significant capital infusion. However, their growth potential hits a ceiling beyond which aggressive scaling becomes difficult. 

Let’s illustrate this concept with a familiar example.

Year 1:

Initial Investment: Rs. 10 lakh

Annual Sales (Revenue): Rs. 15 lakh

Annual Expenses (including salaries, software licenses, and overhead): Rs. 10 lakh

Annual Profit: Rs. 5 lakh

Year 2:

The startup continues to operate with the same initial capital.

Annual Sales: Rs. 20 lakh

Annual Expenses: Rs. 12 lakh (due to some expansion in the team)

Annual Profit: Rs. 8 lakh

Year 3:

Still using the same initial capital.

Annual Sales: Rs. 25 lakh

Annual Expenses: Rs. 14 lakh

Annual Profit: Rs. 11 lakh

The key point here is that, despite growing their sales and profitability, the startup hasn’t needed to invest significant additional capital beyond their initial Rs. 10 lakh. They’ve been able to efficiently use their existing resources (computers, software, team) to handle more clients and generate higher revenue.

The second category encompasses the majority of businesses that need to reinvest profits to fuel growth. Here, the focus lies on incremental RoCE and the sustainability of growth over time.

Longevity of Growth:

Sustaining growth at lower double digits for 3-5 years does not create significant shareholder value. However, if a company can maintain this growth for 20-25 years, it unlocks the magic of compounding. Few, like HDFC Bank and Bajaj Finance, can achieve such sustained growth.

Incremental ROCE:

When a company reinvests profits, what matters most is the incremental RoCE it can earn and the capital available for reinvestment. Typically, businesses can reinvest a maximum of 100% of their profits. Some outliers, like Bajaj Finance, have exceeded this by raising additional equity. This ability to reinvest profitably explains why these businesses often trade at a premium.

Years

Opening EPS Reinvested EPS ROCE

Closing EPS

0 100 80 27.07 127.07
1 127.07 101.65 34.39 161.46
2 161.46 129.17 43.7 205.16
3 205.16 164.13 55.53 260.69
4 260.69 208.56 70.56 331.26
5 331.26 265.01 89.66 420.92
6 420.92 336.73 113.93 534.85
7 534.85 427.88 144.77 679.61
8 679.61 543.69 183.95 863.57
9 863.57 690.85 233.74 1097.31
10 1097.31 877.85 297.01 1394.32
11 1394.32 1115.45 377.4 1771.72
12 1771.72 1417.37 479.55 2251.27
13 2251.27 1801.01 609.35 2860.62
14 2860.62 2288.49 774.28 3634.9
15 3634.9 2907.92 983.86 4618.76
16 4618.76 3695.01 1250.16 5868.92
17 5868.92 4695.13 1588.54 7457.46
18 7457.46 5965.97 2018.51 9475.97
19 9475.97 7580.78 2564.86 12040.83
20 12040.83 9632.67 3259.09 15299.93
  P/E 152.9993    

 

In this table, we’re looking at how a company’s earnings per share (EPS) grow over 20 years when they reinvest 80% of their earnings at a 34% Return on Capital Employed (ROCE). 

Here’s a simple summary:

Year 0: The company starts with an EPS of 100 and reinvests 80% of it, resulting in a ROCE of 27.07%. The closing EPS for Year 0 is 127.07.

Over the next 20 years, the company continues to reinvest its earnings and achieve a growing ROCE.

Year 20: After two decades of reinvestment, the closing EPS reaches 15,299.93.

The Price-to-Earnings (P/E) ratio at Year 20 is approximately 153, indicating that investors are willing to pay 153 times the company’s earnings per share for its stock.

Conclusion: Consistent reinvestment at a good ROCE can lead to significant growth in earnings per share and, in turn, potentially justify a high P/E ratio for the company’s stock.

Years Opening Eps Reinvested EPS ROCE Closing EPS
0 100.00 30.00 10.50 110.50
1 110.50 33.15 11.60 122.10
2 122.10 36.63 12.82 134.92
3 134.92 40.48 14.17 149.09
4 149.09 44.73 15.65 164.74
5 164.74 49.42 17.30 182.04
6 182.04 54.61 19.11 201.16
7 201.16 60.35 21.12 222.28
8 222.28 66.68 23.34 245.62
9 245.62 73.69 25.79 271.41
10 271.41 81.42 28.50 299.91
11 299.91 89.97 31.49 331.40
12 331.40 99.42 34.80 366.19
13 366.19 109.86 38.45 404.64
14 404.64 121.39 42.49 447.13
15 447.13 134.14 46.95 494.08
16 494.08 148.22 51.88 545.96
17 545.96 163.79 57.33 603.28
18 603.28 180.98 63.34 666.63
19 666.63 199.99 70.00 736.62
20 736.62 220.99 77.35 813.97
P/E 8.1396895

 

When we adjust the variables, reducing the reinvested earnings to 30% and increasing the Return on Capital Employed (ROCE) to 35%, the Price-to-Earnings (P/E) ratio experiences a significant decline. In this scenario, the P/E ratio drops substantially to approximately 8.

Read: Low P/E Stocks A Great Bargain Or A Trap?

This change illustrates the critical relationship between reinvestment and ROCE in influencing a company’s valuation. A higher reinvestment rate coupled with a lower ROCE can lead to a lower P/E ratio, which can impact how investors perceive the company’s stock in terms of its price relative to its earnings.

This phenomenon explains why a business with a 100x earnings ratio can be considered cheap if it exhibits strong fundamentals, while a mediocre business with a 20x earnings ratio may be excessively expensive. The valuation dissonance is evident, particularly among PSU companies with low RoCE and reinvestment rates.

In conclusion, identifying companies with exceptional management capable of achieving high reinvestment rates at substantial incremental RoCE for extended periods can lead to seemingly high valuations that are justified by sustainable growth prospects. Understanding these fundamental principles is the key to successful investing.

Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. It is based on several secondary sources on the internet and is subject to changes. Please consult an expert before making related decisions. 
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