The search for profitable investment opportunities on Wall Street - equities that have the potential to beat market averages - begins with a simple question for me: what do these publicly-traded firms do for investors?
Another important question to consider is whether to allocate money in different business opportunities, i.e. coffee-shops, burger chains, electric car manufacturing, retail stores, electronic trade, software development, etc., or to be more concentrated. Rather than buying stocks, investors could also buy stock or bond ETFs, in which shareholders or corporate debt holders hand their money to managers of different firms to invest it for them.
The basic premise of all good investments is that the managers can deliver a higher return on invested capital (ROIC) - which is a measure of how efficient a firm is at allocating capital to profitable business opportunities - than it pays in the weighted average cost of capital (WACC), or the amount of investment dollars it takes to generate the return on invested capital.
How can investors determine the effectiveness of different firms in investing their money? Here is a four-step process that I use:
- Calculate the ROIC for a group of firms
- Calculate the WACC of these firms
- Rank the differences between ROIC and WACC for all firms in the group
- Consider the shares of the firms with ROIC that exceeds WACC as potential investments, as they will likely enhance value as sales grow.
These steps are easy to perform these days, as both ROIC and WACC can be found in many financial sites, including GuruFocus - see two examples below:
Example 1: Qualcomm (QCOM, Financial) and Intel (INTC, Financial)
| Company | ROIC | WACC | ROIC-WACC difference |
| Qualcomm | 14.35% | 6.08% | 8.27% |
| Intel | 18.89 | 3.91 | 14.98 |
Source: Compiled from GuruFocus on Nov. 5, 2020
Example 2: Uber (UBER, Financial) and Lyft (LYFT, Financial)
| Company | ROIC | WACC | ROIC-WACC |
| Uber | -23.3% | 0.00% | -23.3% |
| Lyft | -47.39% | 0.00% | -47.39% |
Source: Compiled from GuruFocus on Nov. 5, 2020
Once investors have gone over these steps, they must then determine whether the firms chosen have a sustainable competitive advantage. If they do, then they likely can maintain an ROIC in excess over WACC over a long period of time.
For a more complex model, investors can attempt to connect ROIC to competitive advantage mathematically, as follows:
"ROIC = (1-Tax Rate) (Product Price-Average Cost/Invested Capital per Unit)"
Firms with innovative products and a strong brand (e.g., Apple (APPL), Nike (NKE), Qualcomm and Intel) can charge a premium price for their product, and therefore are expected to have a higher ROIC than the competition.
Likewise, firms with a scale advantage (e.g., Walmart (WMT and Amazon (AMZN)) have a low Average Cost, and therefore are expected to have a higher ROIC than the competition.
Disclosure: I own shares of Qualcomm and Intel
Read more here:
- Uber and Lyft: Good Companies, Bad Investments
- Alibaba's 2 Weak Spots
- Qualcomm Has Found Its Magic Again
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