The Value Investor 500

I want [insert your company here] to be among the U.S.' top 500 companies within five years.

How would you define the top companies in the U.S.? Every year Fortune publishes its highly regarded Fortune 500, a list of the top 500 companies in the U.S. by revenue. For investors, though, is that really how you would define the top companies? While the revenue a business brings in is important, it should never be the gauge for the success of a business or management team. As an investor, I believe the most important measure for investors is the return a company earns on the cash it invests. Read on for a better method of defining the top companies in the U.S., a look at the top 10, and a surprising quality that six of the top 10 share.

The top 500 companies in the U.S.
To be fair to Fortune, the Fortune 500 is not meant to define the leading companies in the world, only to "serve as a snapshot of the state of American Business." As Fortune's Allan Sloan stated last year, "The 500 is based on U.S. based companies' publicly reported revenues, not on any quality-based metrics: You get high-grade companies like Warren Buffett's Berkshire Hathaway (No. 7) nestled near utter dogs like Fannie Me (No. 5.)."

To construct a quality-based list of the top 500 companies in the U.S. I focused on what's really important for investors to pay attention to:

  1. The amount of cash a company generates: free cash flow.
  2. How much capital it took to earn that cash: pre-tax return on invested capital.

Free cash flow
To select the top 500 publicly traded companies in the U.S., I started with the 500 companies with the largest free cash flows as of the end of 2011. Free cash flow is what a company has left over at the end of the year after paying for all the salaries, bills, interest on debt, and taxes, and after making capital expenditures to expand the business. It is the gold standard by which to measure the profitability of a company's operations.

The list was then rank ordered by the companies' five-year average pre-tax return on invested capital. As business guru Jim Collins recently opined, "In sports, your team has to win championships, or it really can't be called a great team. In business, the measure is financial -- return on invested capital. I think that, to be considered great, a company must have sustained returns on invested capital substantially in excess of other companies in its industry."

This one-size-fits-all calculation cuts out many of the legal accounting tricks (such as excessive debt) that managers use to boost earnings numbers, and provides you with an apples-to-apples way to evaluate businesses, even across industries.

By ranking the companies by pre-tax ROIC, companies that earn their investors notable returns are highlighted, not just companies that increase their capital base. The few companies with greater than +500% or -500% ROICs were reduced to 500% to limit the effects of abnormally low invested capital. 

The resulting list is a qualitative look at the top 500 publicly traded companies in the U.S. While nowhere near perfect, it is intended to be representative of the 500 best performing publicly traded businesses today. In the top 10, there are some surprises but also some of the names you might expect such as Apple and Mastercard. For the full 2012 Value Investor 500, click here.

2012 Value Investor 500 Top 10

1

Terra Nitrogen (NYSE: TNH  )

Sells fertilizers ammonia and urea ammonium nitrate. The commodities have taken off in demand and price over the past few years, while one of Terra's biggest costs -- natural gas -- has cratered in price. The company has been reaping the rewards.

2

Apple (Nasdaq: AAPL  )

Surprised Apple's not No. 1? The largest company in the U.S. by market cap has been dominating the consumer electronics markets the past few years with iPhones, iPods, iPads, MacBooks, and more.

3

Altera (Nasdaq: ALTR  )

Leader in the programmable logic chip device industry. The company eschews the top-of-the-line chips and focuses on niche markets, which have less competition and higher margins.

4

Mastercard (NYSE: MA  )

The second largest payment processor in the U.S. behind Visa.

5

Apollo Group (Nasdaq: APOL  )

For-profit education company that runs the University of Phoenix.

6

Accenture

Management consulting, technology services, and outsourcing services firm. With minimal real assets besides its people, Accenture is a cash flow machine.

7

TD AMERITRADE 

One of the top online discount brokers. The company has been buying back shares over the past few years, and it began paying a dividend last year.

8

Moody's 

The largest providers of debt-rating services and analysis, with nearly 40% market share in the U.S.

9

ITT Educational

Education company that runs ITT Technical Institutes around the U.S.

10

Linear Technology 

Provides integrated circuits that enable gadgets in cars, computers, iPhones, and even the Mars rover.

For the full 2012 Value Investor 500, click here.

The surprising quality that six of the top 10 share
I mentioned earlier that six of these 10 companies all have a surprising quality. It's that they are recommendations of Motley Fool investing services: Apple, Accenture, TD AMERITRADE, Linear Technology, Moody's, and Mastercard round out the list.

My recommendation to you is to check out the full 2012 Value Investor 500 and let me know what you think in the comments section below. If you are looking for more, we recently singled out three Value Investor 500 stocks in a free report called "3 American Companies Set to Dominate the World." These three companies all have strong brands, generate large amounts of free cash flow, and have high ROIC.

Dan Dzombak can be found on his Facebook page. Click here and like his Facebook page to follow his investing articles. The Motley Fool owns shares of Mastercard. The Fool owns shares of Apple. Motley Fool newsletter services have recommended buying shares of Moody's, Apple, Linear Technology, Accenture Class A Ordinary, and TD AMERITRADE; and creating a bull call spread position in Apple. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (4) | Recommend This Article (46)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 20, 2012, at 12:37 AM, mikecart1 wrote:

    Interested in 1, 3, and 10 on your list. The others are talked about so much I sometimes think I actually work at some of those places lol.

  • Report this Comment On June 20, 2012, at 1:18 PM, mrtavs wrote:

    Very interesting and worth pursuing further It would be helpful if Dan could share the source of the numbers and how pre-tax ROIC was calculated? Thanks

  • Report this Comment On June 29, 2012, at 7:35 PM, OldSchoolValue wrote:

    Great job with this list. I know first hand how long and time consuming it is to provide a list like this. Thanks for sharing.

    Jae Jun

    http://www.oldschoolvalue.com

  • Report this Comment On July 09, 2012, at 10:28 PM, RukeyserWasRight wrote:

    Excellent food for thought, thank you. The next step will be to figure out a metric for volatility and sustainability. For example, I refuse to buy dot-coms, banks and credit-card companies because there are simply too many ways to jiggle the numbers. I refuse to buy Apple because I remember the days when IBM was growing 15% + per year and people thought it would go on forever.

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