Return on Capital: The Engine of Compounding

"A company that earns 20% on equity and retains its earnings will grow intrinsic value at 20% per year — no magic required."

Here is one of the most useful relationships in investing:

Sustainable growth rate = return on invested capital × the share of earnings reinvested.

If a business earns 20% on its capital and reinvests three-quarters of its profits, it grows its intrinsic value at about 15% a year — by arithmetic, not luck.

Return on invested capital is doing three jobs at once. It is the rate at which the business grows its own value; the rate your capital compounds if you buy at a fair price and hold; and the ceiling on how much it can sustainably pay out in dividends and buybacks.

This is why two companies with identical earnings-per-share growth can create wildly different value. One funding its growth at an 8% return is destroying value to grow; the other, at 25%, is a compounding machine. The growth rate alone tells you very little until you know the return behind it.

Illustrative example: same market, different engines

Two builders operate in the same housing market with similar revenue growth. One uses an asset-light model that earns far higher returns on capital than the other. Over decades, that difference in the return engine — not the top-line growth — produced a vast gap in value created.