The sweet spot of wealth compounding

Find out the key characteristics of wealth-compounding machines

- Saurabh Mukherjea

The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine.

Warren Buffett, The Snowball: Warren Buffett and the Business of Life Marcellus' investment philosophy has centred around investing in ideal wealth compounders with three C's - clean balance sheets, competitive advantages and capital allocation skills. This potent combination allows businesses to generate free cash flows (FCFS) and grow them sustainably over the long term at a healthy rate.

But before diving into why these are key characteristics of a compounding machine, we must explore what FCF and return on capital employed (ROCE) are and why they are pivotal for longterm growth.

Understanding FCF and ROCE: key drivers of investment value

FCF is the cash left over after paying for operating expenses (cost of raw materials, payroll expenses, etc.), capital expenditures (new plants, machinery, etc.) and increases in working capital (money set aside to meet short-term obligations like payments to vendors, etc.).

But why is it important? Well, income statement parameters like operating profit (EBITDA), net profit (PAT) and per-share earnings (EPS) - do not adequately reflect how efficiently the capital of the company is being utilized to generate earnings. Furthermore, metrics like PAT are also prone to accounting shenanigans (for example, by tweaking the depreciation method and reducing depreciation expenses to increase reported profits).

ROCE is the measure of how much profit a company can churn out from using its invested capital in the business. To achieve future profit growth, additional capital needs to be deployed back into the business. This additional capital is dependent on a company's ROCE. The higher the ROCE of a company, the lower the additional capital required to generate profit growth.