“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” – Warren Buffett, 1992 Berkshire Hathaway Shareholder Letter.

Investing is putting money into different securities or investment vehicles, hoping these securities will increase in price and payout profits.

In particular, investing in the stock market involves buying shares of companies that then rise in price. Some companies also pay dividends on their shares at regular intervals.

The end goal of investing is to spread your wealth in different vehicles that grow your money over time.

“Don’t be afraid to overpay for a stock with a history of rewarding shareholders. Winning stocks tend to keep winning if you have a long-term outlook.”  Charlie Munger convinced Warren Buffett that sometimes it’s worth paying a premium for a great business.

A company’s intrinsic value is the present value of all of its future free cash flows (meaning from now until the end of time- all the free cash flows that it will ever generate).

Free cash flow (FCF) is the amount of cash the firm generates from its operations minus the amount of money it reinvested into its operations. Cash flows are “free” because they can be used to pay off debt, buy back shares, pay dividends, or leave in the firm’s bank account.

If you own a private company, this is what you would think of as “real earnings” that you can pay yourself with, given that you don’t have to reinvest those funds into the operation.

”Good things happen to cheap stocks of out-of-favor, industry-leading companies.” ~ Nancy Tengler

The most crucial quantitative evidence of an economic moat is a high return on invested capital (ROIC).

Return on invested capital, or ROIC, is a financial metric that helps understand how efficiently a company generates profits. The less capital it requires to produce earnings, the better.

For example, what does an ROIC of nearly 920% mean? It basically says that a company like Apple can generate massive profits with little investment.

The formula for ROIC is highlighted below. To reinforce, the larger the numerator (NOPAT is the after-tax operating profit) relative to the denominator (which can be defined as fixed assets plus net working capital), the more efficient the company is.

Investors— both shareholders and creditors— require a certain level of return in exchange for providing a company with the funds it needs to run its business. This is called the weighted average of capital (WACC). A company generates excess returns if its ROIC consistently exceeds its WACC.

For example, imagine little Joey wants to open a lemonade stand. He needs $100 upfront to buy a table, a pitcher, lemons, sugar, ice, and cups. This is invested capital. Joey borrows $50 from Mom and promises to pay her 5% interest ($2.50). Dad has a higher risk tolerance, so he buys $50 of common stock in Joey’s lemonade stand. Dad equity return (this is called the cost of equity).

Buffett created a concept called owner earnings. It is a measure of the firm’s potential free cash flows if it weren’t reinvesting them:

Owner Earnings = Earnings + Depreciation & Amortization + Other Non-Cash Charges – Maintenance Capital Expenditures

Attaining prosperity and financial freedom and building wealth through investing in the stock market for the long term is fundamental.

References:

1. https://www.forbes.com/sites/qai/2022/01/19/financial-freedom-in-2022-investing-in-stock-market-ideas
2. http://www.comusinvestment.com/blog/growth-returns-on-capital-and-business-valuation
3. https://einvestingforbeginners.com/buffetts-return-on-invested-capital-formula-daah/