“Return on Invested Capital and HoldCo Growth”
Return on Invested Capital (ROIC) measures how much a company earns on newly invested capital.
Easy example, a restaurant business currently has 10 locations earning $1m in EBITDA per year. Each new location costs $300k to build out and adds $100k in EBITDA. That is a new store level ROIC of 33%.
There are multiple ways to measure ROIC. The point of this post is not to discuss them all. It is to make you aware of the concept and grow your understanding when analyzing businesses and investment decisions.
When making an investment or purchasing a company, what you are buying are future cash flows. The past cash flows went to the previous owner.
Where do those future cash flows come from? They come from the company as it is today plus any additional cash flow which can be produced from new investments. A company's ability to grow is determined by how much cash they deploy for growth multiplied by the return on that investment, the ROIC.
In the restaurant example above perhaps the next 10 restaurants you open provide a 33% ROIC. Eventually, that number comes down. Market saturation, operating difficulties, and new competitors do a great job of siphoning off excess returns. This is why so few businesses grow to be huge companies.
The ROIC for continued expansion becomes unattractive and the owners either continue plowing money into ever less atrractive opportunities or simply take a dividend and do something else.
The moment ROIC in new investments stops making sense is different for each company, geography, and management team.
A restaurant chain in Panama will have a much lower ceiling than a chain in the USA. Based simply on the fact there are around 10x the population in the USA to serve food to.
One of a CEO's most important jobs is to estimate which growth projects provide the most attractive ROIC. This is no different for a HoldCo CEO.
The essence of a HoldCo is it opens the panorama of investment options. Allowing for a never ending stream of opportunities to find the best ROIC.
Rather than only being able to open new restaurants, a HoldCo CEO can choose between reinvesting in a multitude of existing operations or going outside the group and acquiring a whole new business line.
A HoldCo provides for what should be a higher ceiling for growth than a traditional business.