The Role of Quality in Compounding Intrinsic Value

If our goal is to compound capital at the highest rate while minimizing risk (permanent loss of capital), buying high quality businesses demands more focus than paying the lowest price. Return on tangible capital employed measures the quality of a business. High quality businesses combine high returns on tangible capital employed with long-term opportunities to reinvest earnings at similar high rates and management that allocates excess cash in accretive ways (ie. dividends/buybacks or acquisitions).

There are three categories.

High quality businesses with high returns on tangible capital employed and low capital requirements: grow organically by increasing volume/price, sell products for cash to eliminate accounts receivable, maintain short production/distribution cycles and minimal inventory, leverage intangible assets like brand or other intellectual property, and return capital to shareholders as dividends/buybacks (ie. Visa in Credit Services)
High quality businesses with high returns on tangible capital employed and high capital requirements: grow by reinvestment or increasing net working capital/property, plant, and equipment (ie. Union Pacific in Railroads)
Low quality businesses with low returns on tangible capital employed and high capital requirements: destroy value by reinvestment or increasing net working capital/property, plant, and equipment (ie. Airlines)

For a long-term investment (10+ years) that involves shared ownership in a business, simple math explains the importance of quality to compounding. A back of the envelope method to estimate growth in the intrinsic value of a business takes the product of return on incremental invested capital and reinvestment rate. However, it's also necessary to understand the strength and durability of a business's competitive advantages, which sustain its return on tangible capital employed/incremental invested capital.

Expectations of Three Different Companies

Company A reinvests 40% of earnings for a 50% return and distributes 60% of earnings as dividends.

In year 0, the stock price per share, earnings per share, and dividend yield are $30.00, $1.00 (30 P/E), and 2.00%, respectively.
In year 10, the earnings per share is $6.19 and the stock price per share with various price-to-earnings ratios is...

15 P/E: $92.88 per share (13.96% CAGR)
20 P/E: $123.83 per share (17.23% CAGR)
30 P/E: $185.75 per share (22.00% CAGR)

Company B reinvests 100% of earnings for a 18% return.

In year 0, the stock price per share and earnings per share are $25.00 and $1.00 (25 P/E), respectively.
In year 10, the earnings per share is $5.23 and the stock price per share with various price-to-earnings ratios is...

15 P/E: $78.51 per share (12.12% CAGR)
20 P/E: $104.68 per share (15.40% CAGR)
25 P/E: $130.85 per share (18.00% CAGR)

Company C reinvests 75% of earnings for a 8% return and distributes 25% of earnings as dividends.

In year 0, the stock price per share, earnings per share, and dividend yield are $10.00, $1.00 (10 P/E), and 2.50%, respectively.
In year 10, the earnings per share is $1.79 and the stock price per share with various price-to-earnings ratios is...

10 P/E: $17.91 (8.50% CAGR)
15 P/E: $26.86 (11.89% CAGR)

Although the price-to-earnings ratio is important in the short-term, future returns of the underlying business are what determine intrinsic value. The high multiples of Company A/Company B prove reasonable because the businesses are high quality. The growth in earning power is far more significant than the change in multiple, over the long-term. But nothing is worth an infinite price.

Gains in a stock are subsequent to the internal results of a business. The low multiple of Company C offers a larger margin of safety, but the average quality of the business lowers the probability of achieving an unusually high return.

Finally, the longer the investment duration, the wider the gap between Company A/Company B and Company C. In year 15, the CAGR with a 15 P/E is 17.91%/15.02% and 10.67%, respectively. Time is the friend of a good business.

References

Operating income is a proxy for earnings before interest and taxes (consistent over time and across capital structures). Tangible capital employed is the physical assets that the business needs to operate. Return on tangible capital employed compares the profit generated by the business to the capital requirements of the business. Return on incremental invested capital is the value created by each additional dollar that's added to the business over time. Reinvestment rate is the percentage of earnings that can be retained by the business and deployed into future opportunities.

operating income = gross profit - operating expenses
net working capital = (accounts receivables + inventory + other current assets) - (accounts payable + deferred revenue + other current liabilities)

if net working capital is negative, replace with zero

tangible capital employed = net working capital + property, plant, and equipment
return on tangible capital employed = operating income / tangible capital employed
return on incremental invested capital = change in operating income / change in tangible
reinvestment rate = change in tangible capital employed / sum of operating income
intrinsic value compounding rate = return on incremental invested capital * reinvestment rate