It’s incredible that corporate executives and the market as a whole continue to depend on such flawed numbers when we already have a measure that is clearly linked with value creation: return on invested capital (ROIC).
Why do investors, executives, and the financial media focus on reported earnings and other metrics such as EBITDA that ignore the balance sheet? Why aren’t executives around the world adopting ROIC in order to boost returns?
Investors looking for value need to take a holistic approach that measures a company’s ability to deliver economic earnings to investors and quantifies the expectations for future cash flows embedded in its current stock price.
Recently, we ran through the various flaws in the price to earnings ratio and explained why investors need to be paying more attention to return on invested capital (ROIC). This week, we’re tackling another of the market’s favorite metrics, return on equity (ROE). Return on equity has a very simple formula: It’s tempting to think…
Last month, Fortune released its list of the top 50 businesspeople of the year. The recognition these CEO’s are receiving shows that the market cares about ROIC, even if many investors aren’t explicitly talking about it.
What do these companies have in common? They are the only surviving S&P 500 stocks to rise 10% or more in 2008. In the midst of a collapsing market and the subsequent damage, these seven stocks made good money for investors.
We’ve pointed out the flaws in the price to earnings (PE) ratio many times before. Chief among these flaws is the fact that the accounting earnings used in the ratio are unreliable for many reasons:
Unadjusted GAAP earnings already obfuscate true profits enough, and non-GAAP earnings lead investors even farther astray. In turn, non-GAAP earnings are often used to line the pockets of insiders at the expense of shareholders.
Analysts and investors tend to spend very little time on Goodwill when looking at financial statements. In reality, Goodwill is an important number to keep an eye on. Since it reflects the money paid for acquisitions above the market value of the acquired company, it can signal overpayment, reckless spending, and the potential for damaging write-downs in the near future.
In truth, neither AMZN’s $5.5 billion of operating cash flow nor the $1 billion in free cash flow that bulls claim reflect the actual economics of the business.
The second step to gauge the value of a company is to determine the sum of all cash that has been invested in a company over its life without regard to financing form or accounting name. We call this Invested Capital.
A high quality smartphone from Amazon that undercuts higher-priced competitors could mean more serious trouble for Apple’s iPhone and the company’s declining profit margins.
A disconnect between investment theory and investment practice exists and is manifested in the way investors should value stocks versus the way they actually do value stocks.
New Constructs released September’s Most Attractive Stocks report to the public today.
The Most Attractive Stocks portfolio (+5.8%) outperformed the S&P 500 (+4.4%) last month. There are 16 new stocks in the Most Attractive portfolio for this month.
Overfunded pension assets are similar to excess cash, and should not be included in the calculation of return on invested capital (ROIC).
Deferred compensation plans delay employee compensation until a later date. The assets held for these plans are used to compensate employees in the future, not to generate profits for the company. As such, they should not be factored into the calculation of a company’s return on invested capital (ROIC).
The Most Attractive Stocks portfolio (+1.9%) outperformed the S&P 500 (+0.4%) last month.
Reported assets don’t tell the whole story of the capital invested in a business. Accounting rules provide numerous loopholes that companies can exploit to hide issues and obscure the true amount of capital invested in a business over its life.
Converting GAAP data into economic earnings should be part of every investor’s diligence process. Performing detailed analysis of footnotes and the MD&A is part of fulfilling fiduciary responsibilities.
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