Reinvestment and growth

In this post, we explore what reinvestment means and its relationship with expected growth

In the book ‘100 Baggers’, Christopher Mayer outlines two important characteristics in the making of a multibagger stock. 1) High returns on capital 2) Reinvesting opportunities at higher returns. If the firm is earning high returns on the capital and at the same time has the ability and/or opportunity to keep on reinvesting those earnings at higher returns, the results are pretty dramatic in the long run. In this post, we will concentrate on what reinvesting means, how we can measure it, and its relationship with the growth potential of the firm.

Simply put, reinvestment simply means ploughing back the profits into the business. When an existing business generates profits, the firm can invest those profits back into the business or distribute them to the shareholders in the form of dividends. Reinvestment in the business can be in the form of acquiring new assets through acquisitions or expanding existing capacities. However, the scope of reinvestment isn’t limited to building or acquiring just physical assets. Developing an intangible asset like software or know-how, patent, etc. can also be categorized as reinvestment.

Remember retention ratio?

Retention ratio = 1 - Dividend Payout Ratio 

If you consider net earnings, a 40% dividend payout means that 60% of the earnings are retained and invested back in the business. However, we will broaden this concept and consider operating profits after tax (NOPAT) instead of net profits in the denominator since it’s a better proxy for the operating cash flows. For reinvestment in the numerator, we will consider (i) net capex and (ii) change in working capital during the year. The ratio of these two gives us the reinvestment rate for the particular year.

Reinvestment rate = Capital expenditure - Depreciation + ⧍ working capital

EBIT x (1-tax rate)

Reinvestment trends and lifecycle stage

In the growth stage, firms tend to redeploy earnings back into the business and distribute less to the shareholders. Thus higher reinvestment rates are an indication that there is a long runway for growth from top management’s perspective. When firms reach the maturity stage, reinvestment rates tend to go lower, and the pendulum shifts toward higher dividend pay-outs. Trends in the reinvestment rates help us figure out the stage of the firm in the lifecycle.

Relationship between reinvestment rate and growth

Reinvestment rates set the expectation of the firm's future revenue and operating profit growth. At the firm level, growth is the function of the returns on capital generated by the firm and incremental investment in the business. Of course, there are macro factors impacting the growth but they are outside the control of the firm. Hence, we will consider the reinvestment rate and the firm’s ROIC as building blocks for future growth.

Growth = Reinvestment rate * ROIC (Return on capital) 

Elaborating the above formula,

Growth = Capital expenditure - Depreciation + ⧍ working capital x EBIT (1-tax rate)

EBIT (1-tax rate) Invested capital

Other things equal, the above formula provides a reasonable base for the growth projections at least in the near future. However, this formula works well for the firms that have identifiable growth levers and are not in the very nascent or initial growth stage.

One important consideration in the reinvestment rate formula discussed above is that we have taken net investment in fixed assets and working capital in the numerator. Whist this is appropriate for manufacturing firms, we need to make some adjustments for the firms in sectors where investment in the business is not always reflected in terms of fixed assets or working capital. For example, R&D expenditure for pharma and technology firms or Marketing and Promotional expenditure for FMCG firms. These expenses are not absolutely operating in nature as the benefit of these expenses are derived well beyond the year in which they are incurred. This is why these expenses should be considered along with the Capex to calculate the reinvestment rate.

ROIC denotes return on capital and its calculation is fairly straightforward. We take operating assets deployed in the business in the denominator and ignore cash & cash equivalents. This is because the growth is primarily generated from the operating assets including intangible assets such as trademarks, patents, etc. In the numerator, we take Net Operating Profit After Tax (NOPAT) which is nothing but EBIT x (1- tax rate).

High reinvestment rates are followed by high growth rates depending on the ROIC of the firm. Lack of growth after reinvestments reflects inefficient utilization of capital and is a sign of concern. It means that either the growth strategy of the firm is on a weak footing or the industry itself is in the declining stage with many firms vying for market share. Hence, to benefit from high reinvestment rates, there has to be a large addressable market and/or the firm should have some sort of competitive advantage to keep growing faster than the competition. The below scenarios will help us understand this better.

Scenario 1: A specialty chemical company in the growth stage with industry tailwinds

The company has consistently maintained higher reinvestment rates over the years coupled with increasing ROIC. This means that reinvestment is done at incrementally higher returns on capital. The market environment has also remained favorable with limited competition. This has resulted in a CAGR of 18% in revenue and 23% in operating profits over the last decade.

Scenario 2: An FMCG company in a mature stage with industry headwinds

In this example, reinvestment also includes advertisement and promotional spend since it’s an FMCG company. One thing to notice here is that despite very high reinvestment rates and ROIC, the company has registered a CAGR of 7% in revenue in the last decade. Further, the company has not been able to sustain growth in operating profits. This shows that the company has spent on advertisement and promotions just to defend its position and has not been able to gain market share and thereby grow topline and operating profits meaningfully.