One of the students asked a Question on Returns on incremental capital employed/Invested. Here is a detailed answer with examples which I tried to answer with:-
Hi Sai!!
Incremental ROCE simply means how much return are you making on incremental capital employed.
Simple Example: (One hypothetical and one with a real life business case study)
Incremental ROCE simply means how much return are you making on incremental capital employed.
Simple Example: (One hypothetical and one with a real life business case study)
1. Suppose you own a shop and your shop makes 20% Return on invested capital. Basically, you have put in 100 rs of capital and you are making 20 rs of return on capital invested.
2. Now, given you have made an additional rupee 20 (that is 20% on capital invested). This bit of capital gets freed up for you to invest in future capital allocation endeavors.
3. Now, lets say that you find another neighborhood where you can open one more shop and earn 20% even on top of that. Thus, your incremental return on invested capital= 20%. As you used 20% generated by your business to generate another 20% on top of it.
This was with a simplistic assumption. All incremental capital that gets invested in the business, will show up in average ROCE or ROIC of a business over 3-4 years. Sometimes incremental ROIC or ROCE can further improve. Here let me give you a real business example:-
1. PI industries is a business which has been generating 25-30% ROCE over a period of time.
2. As they could keep redeploying the cash flows. Do you know what has happened?
2. As they could keep redeploying the cash flows. Do you know what has happened?
3. This company used to have 1 Multi Product plant in 2010..Now just due to the sheer reinvestment of capital, (putting up more shops). By the end of FY24, this company will have 17 plants!!
4. The entire incremental capital has been invested at 25-30% returns.
4. The entire incremental capital has been invested at 25-30% returns.
5. Core Earnings Growth is nothing but= ROIC*REINVESTMENT RATE. Reinvestment rate in PI has been nearly 90% of their capital which goes into capex.
6. Currently you might see their ROCE to be depressed, as they have raised further 2000 crores to invest in Pharma ventures, lets see what and when the returns on incremental capital come on this new venture.
To simply calculate Return on incremental capital employed=
Take DEBT+EQUITY-(EXCESS CASH on the Balance sheet) of lets say 2017. Subtract it with Debt+equity-(excess cash) of 2022. This will give you the denominator.
Take DEBT+EQUITY-(EXCESS CASH on the Balance sheet) of lets say 2017. Subtract it with Debt+equity-(excess cash) of 2022. This will give you the denominator.
Take EBIT of 2017 and subtract it by EBIT of 2022. Incremental delta or change will be your numerator.
Divide the two and you will get your Return on incremental capital employed!
Divide the two and you will get your Return on incremental capital employed!
Businesses like Rainbow, KEI, VBL, SRF etc. Have demonstrated their ability to deploy incremental capital at high rates of return. This is a key mental model for you to think about businesses. As size of opportunity, capital allocation and business strategy decides your Returns!
Disclaimer: This is not a thread on valuations. But simply an answer to the question on ROIIC or incremental returns on capital employed!
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