Temptation abounds in the market, and I'm not just talking about the risks you can find with high-flying growth stocks. Even a real stock skinflint -- by which I mean a "value investor" -- has to watch her step, because there are two kinds of cheap: good and bad. There's "Woohoo! I can't believe this is so cheap!" and then there's "Cheap and likely to stay that way."
How can you tell the difference between the two? It's not always easy, but when we eyeball a pile of prospective bargains, one of the first things my colleagues at Motley Fool Inside Value and I do is take a glance at return on invested capital (ROIC). This is a relatively complex measurement for casual investors, and there are varying ways to arrive at it, so beware: This isn't the simplest of yardsticks. That said, ROIC is extremely important. It's one of the finest Craftsmen in my value-investing tool box.
You can savor the juicier details in an article here, but in a nutshell, ROIC is a way of seeing past the bias that debt can inject into the return-on-equity (ROE) metric, a common yardstick for profitability. Technically, in order to truly judge a company's ROIC, you also need to know what it costs to obtain that capital (using WACC, or weighted average cost of capital). If the business returns more than it pays for capital, that's good. If the opposite is true, you'd better hope things change, because that company is destroying value -- something you don't want to be a part of.
I'm going to come clean here. I rarely take the time to hand-figure ROIC and WACC numbers. I find that even a back-of-the-napkin calculation -- which I accomplish via some nifty database software -- or a quick look at an online source can be enough to narrow my field of candidates for further research. When a company's ROIC is 2%, I'm pretty sure it's not beating the company's WACC figure. That percentage runs in the mid- to high-single-digits at most firms. If I see a 19% ROIC, however, I'm inclined to show more interest.
If a company has a crummy record of ROIC, it usually lands in my "out" pile. "Turnarounds seldom turn," Warren Buffett wrote a quarter-century ago, and I tend to believe that. Momentum is a powerful thing, and corporations that make a habit of earning less on capital than they spend to acquire it are simply wasting money. Why play around with these serial losers when the market offers great companies -- ones that actually make more than their capital costs -- during times of panic?
A company like GM
On the other hand, a company like Anheuser-Busch
Does this mean you can never do well with a money-burner like GM? GM's rise in recent months proves otherwise, but over the long term, GM's laggard ROIC is one of the reasons the stock sits right where it did back in the '70s (go ahead and gasp). I wouldn't be surprised to see it languish for years to come.
I'll stick with the smart bets, thanks. Odds are that companies with a long track record of good returns will keep it up. If you can buy them when the market doesn't want them, your chances are even better. Several companies have piqued my interest lately because of their decent ROIC and falling share prices: Radio Shack
If you'd like Philip to take you by the hand and walk you through ROIC and WACC calculations for Coke, click here to take a free 30-day trial to Inside Value. In the new issue coming out next week, he'll use Coke's financial data to show readers how to calculate both.
During your trial, you'll get full access to Philip's other stock picks and the newsletter's message boards, where you can chat to your heart's content with other subscribers and the Inside Value team.
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