ROIIC (RETURN ON INCREMENTAL INVESTED CAPITAL)
We generally use ratios like ROCE, ROIC, ROE, ROA to interpret the capital allocation efficiency of the company. These ratios tell us the efficiency of funds from an extended period of time, where in we consider capital as the pool of money which is being invested from the very start of business commencement. But it is also important to understand the recent capital allocation efficiency and skill, to understand if the business is still able to generate the same or better returns than ROCE.
A business who is able to efficiently able to invest the money from internal accruals will always generate higher returns.
INTERNAL ACCRUALS + EFFECIENT ALLOCATION = GENERATE HIGH RETURNS.
The idea here is to identify businesses which will be able to invest the incremental capital at a higher rate, which will so be called a compounding machine, It is rare, but worth searching for.
Return on Incremental invested capital = Incremental earnings / Incremental invested Capital
For example= for a company
2022- net profit= 250
Capital invested= 1000
Therefore-ROCE= 250/1000= 25%
2024- net profit= 260
Capital Invested= 1025
Therefore-ROCE=260/1025= 25.36%
But,
Incremental Net profit from 2022 to 2024 = 260-250= 10
Incremental Capital Investment from 2022 to 2024 = 1025-1000= 25
Therefore ROIIC(Return on incremental invested capital) = 10/25= 40%
SO, ROIIC > ROCE
A company will be a potential Multi-bagger if its ROIIC > ROCE, which means if it is able to generate higher returns on its incremental or added investments than ROCE, then it will grow at a higher rate, such companies Reinvesting their capital to achieve intrinsic growth. which will enable them to intrinsically grow themselves on their own through reinvestments and are able to reduce Debt obligations quickly.
To understand this better, we can take the example of ROIIC Profiling of ITC -
ITC as a company had grown its Net Income by 11750 cr in 10 years by incremental investment of 47331 cr. Its cumulative net profit for 10 years was 1,47,794 cr in 10 years. Of which it had reinvested 47,331 cr back in the business, achieving a reinvestment rate of 32%. Its ROIIC (11,750/47,331 = 25%), so the actual value compounding rate for the company was = Reinvestment rate*ROIIC which is 7.95%
but the 10 yr stock compounding rate (CAGR) came out to be 6%, So the stock price is not growing as per the value it is creating, which means the stock is undervalued and there is further potential for the stock to grow.
The best businesses are the ones that over an extended period can employ large amounts of incremental capital at a very high rate of return. Identify such businesses and going forward you will have a compounding machine.