Category Archives: Building Wealth
Financial Value = FCF & ROIC
“Strong free cash flow generation, a long runway of free cash flow growth, and the price we pay for it are all that matters to long-term investing success.” ~ Motley Fool
Return on invested capital (ROIC) is the most important financial metric because:
- An increase in ROIC always increases intrinsic business value, but revenue growth does not always increase intrinsic value. Revenue growth only increases the intrinsic value when ROIC exceeds the weighted average cost of capital (WACC).
- Companies with high ROIC outperform the stock market by a country mile.
- Companies with rising ROIC (and high incremental returns on invested capital) outperform the market even more!
While profit, gross margin, operating margin, and revenue are all important, they are still only pieces to the ultimate scores: free cash flow and return on invested capital.
Free cash flow can be calculated from an income statement and balance sheet. Below is the equation.
Free Cash Flow (FCF) =
Earnings Before Interest & Taxes (EBIT) x (1 – Tax Rate)
+ Depreciation and Amortization
– Changes in Working Capital (Growth in Assets – Growth in Liabilities)
– Capital Expenditures (Property, Plant, and Equipment)
This free cash flow is what we care most about because it can be used to reward shareowners by either (1) paying down debt (which reduces the claim that debtholders have on the business and strengthens the company’s financial position), (2) paying a dividend, or (3) buying back stock at attractive prices. Then, any leftover free cash that isn’t used to pay down debt, pay a dividend, or repurchase stock can sit on the balance sheet and be used later (i.e., large cash and net cash positions create optionality value).
Free cash flow margin measures a business’s true economic profitability and cash-generating power. It is simply the number of pennies of FCF a company generates for every dollar of sales.
Free cash flow yield is the inverse of the enterprise value-to-FCF multiple. Thinking in terms of yield allows investors to compare a stock’s FCF yield to the risk-free rate (the yield on the 10-year U.S. Treasury bond), to the yields of other stocks and bonds, and to the yields from investing in real estate (a real estate’s cap rate is calculated as annual net cash flow divided by the purchase price of the property).
FCF yield is the amount of cash (as a percentage of the firm value) a sole owner could take out of the business every year to pay themselves. This is the excess, unencumbered free cash that is left over after investing to maintain and grow the business, and it is calculated as NOPAT less new invested capital, where invested capital is any form of investment including working capital, capital expenditures (property, plant and equipment), or acquisitions.
Return on Invested Capital is usually represented as a percentage or ratio and is calculated as follows:
Return on Invested Capital (ROIC) =
Earnings Before Interest & Taxes (EBIT) x (1 – Tax Rate)
÷ (Total Assets – Cash – Total Liabilities)
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Small-Cap Equities
Many investors steer away from small-cap stocks, wary of their reputation as riskier and more volatile than their larger-cap counterparts. While this can be the case, investors avoid this asset class are missing out. In our opinion, small-cap stocks offer fantastic opportunities for research-driven investors who are able to do the deep dive to find the hidden gems.
Small-cap stocks enjoy several advantages. With close to 3,000 listed U.S. stocks (excluding penny stocks), this category has plenty of companies to analyze. Small caps can offer greater and faster growth potential than their larger peers, as they are earlier in their growth trajectory and have captured just a small portion of their overall target market.
In addition, small caps tend to be underfollowed on Wall Street. On average, a large-cap company is followed by 27 analysts, compared with six for the average small cap. This sparser coverage in part is a reflection of SEC regulations that make it difficult for funds to own more than a certain percentage of a company. The result is that many large mutual funds forego small-cap companies because they cannot take a position big enough to have a material impact on their overall portfolio.
It takes extensive research to spot promising companies early on. Many small-cap stocks fly under the radar,. When compared to large caps, stock returns of smaller companies are more driven by company-specific events and less so by industry and market events.1 This means the skilled stock picker who is able to understand and evaluate a company’s idiosyncrasies has more opportunities in this asset class.
On the downside, small caps can be volatile. As long-term investors, you must be accustomed to riding out short-term volatility and must be willing to selectively take advantage of a downswing to initiate or build a position. As less well-established businesses, small caps can also carry more risk than their larger peers.
Thus, it’s essential as a long-term investor to take a multi-faceted approach to managing risk, which is critical to successful management of a small-cap portfolio.
Emphasizeing fast-growing areas of the economy such as:
- Cloud computing
- Cybersecurity
- Semiconductors
- Defense and aerospace
- Genetics
- Minimally invasive surgical procedures
- Biotechnology and pharmaceuticals
- The use of technology in health care products and services
- Unique retail concepts
Long-term perspective, allows you to do the due diligence needed to gain an in-depth understanding of these companies, including getting to know their management teams and visiting key sites they may hold. It also gives us the chance to research new investment prospects.
You should look for what you believe to be companies with strong management, durable competitive advantages, and open-ended growth opportunities, at an attractive valuation.
Smaller companies can enjoy phenomenal growth in a short period of time. However, as any small-cap portfolio manager can attest, you can have volatility on the downside as well. Although you are long-term investors, the volatility of this asset class demands that you incorporate risk management into every aspect of your investment process.
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Box Breathing: A Simple Stress Buster
Box breathing is a powerful but simple relaxation technique that aims to return breathing to its normal rhythm after a stressful experience.
Box breathing is a simple but powerful technique to calm your mind and body by following a four-second pattern of inhaling, holding, exhaling, and holding.
It is also known as square breathing or Navy SEAL breathing, as it is used by elite soldiers to enhance performance and concentration under stress.
Box breathing can help you lower your heart rate, blood pressure, and anxiety levels, as well as improve your mood, focus, and mental clarity
You can vary the length of each phase according to your preference, but make sure to keep them equal and consistent. You can also use a visual cue, such as a box or a square, to help you follow the rhythm.
To practice box breathing, you need to find a comfortable and quiet place, sit upright, and relax your shoulders. Then, follow these steps: – Breathe out fully to the count of four, emptying your lungs completely. – Hold your breath for another four seconds, keeping your chest still. – Breathe in slowly and deeply to the count of four, filling your lungs with air. – Hold your breath.
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U.S. Economy Fueled by Deficit Spending and A.I. Boost in Productivity
The U.S. economy is growing with much of recent growth fueled by government deficit spending and Artificial Intelligence boost to productivity.
Real GDP rose at a solid 3.3% annual rate in the fourth quarter, and consumer spending was strong in December meaning the first quarter is off to a good start. New home sales came in above expectations and initial jobless claims remain low, although orders for durable goods came in low due to weak demand for aircraft.
All eyes are now on Friday’s jobs report, which we expect to show a gain of about 170,000 while the unemployment rate holds steady. But the strength in employment seems fragile. If we exclude job gains in government, health & education (which are largely funded by government), and leisure & hospitality (still recovering from lockdowns), job growth looks exceptionally weak.
In the last seven months of 2023, payrolls excluding those categories rose only 3,000 per month, the kind of weakness we might expect before a recession. In other words, much of recent growth is fueled by government deficits.
Meanwhile the stock market continues to rally, with the S&P 500 closing at a new record high last Thursday. That’s great, but we aren’t exactly sure what the market sees, writes Brian Wesbury, First Trust Chief Economist.
If the economy remains healthy and keeps growing, it’s very hard to imagine the Federal Reserve cutting short-term interest rates by the 125-150 basis points the markets appear to expect. In turn, less rate cutting than the market expects should be a headwind for equities in 2024.
What would get the Fed to cut rates by 125-150 bps? Either a sharp drop in inflation or a decline in economic growth. While lower inflation is good, can a sharp drop happen without a weak economy? Either way, we don’t think the stock market would like that outcome because they would likely signal lower corporate profits.
Artificial Intelligence and other new and rapidly advancing technologies provide a miraculous boost to productivity. This could keep growth strong, or even accelerate it, while bringing inflation down. In other words, profits up and interest rates down.
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U.S. Economy
The U.S. economy is being fueled by productivity growth due to artificial intelligence and fiscal spending.
According to a report by Goldman Sachs Research, AI could increase US productivity growth by 1.5 percentage points annually, assuming widespread adoption over ten years. The report estimates a growth boost to GDP from AI of 0.4 percentage points in the US by 2034.
The US Bureau of Economic Analysis reported that real gross domestic product (GDP) increased at an annual rate of 4.9 percent in the third quarter of 2023, primarily reflecting rising consumer spending and inventory investment.
AI productivity growth and fiscal spending are the primary contributors to the growth of the US economy. However, other factors could have played a role as well.
Return on Invested Capital
“The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here, a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.” – Warren Buffett, 2007 Chairman’s Letter for Berkshire Hathaway.
Invested capital is the amount of money that has been invested in a business for purchasing inventory, equipment, property, leases, and funding the difference between accounts receivable (i.e., how much money is owed by customers to the business) versus accounts payable (i.e., how much business owes vendors).
Return on Invested Capital (ROIC) is a financial ratio that shows a company’s ability to allocate capital. The standard formula to calculate ROIC is to divide a company’s after-tax net operating profit by the sum of its debt and equity capital.
Once the ROIC is calculated, it is evaluated against a company’s weighted average cost of capital, commonly referred to as WACC. If a company’s WACC is not immediately available, it can be calculated by taking a weighted average of the cost of a company’s debt and equity.
The cost of debt is calculated by averaging the yield to maturity for a company’s outstanding debt. This is easy to find, as publicly traded companies must report debt obligations.
The cost of equity is typically calculated using the capital asset pricing model, or CAPM.
Once the WACC is calculated, it can be compared with the ROIC. Investors want to see a company’s ROIC exceed its WACC. This indicates the underlying business successfully invests capital to generate a profitable return. In this way, the company is creating economic value.
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25 Things About Life I Wish I Knew
Life is all about relationships, health & wellness, purpose, being grateful and mindful, and learning:
- Relationship refers to the state of being related or interrelated to others. It refers to the connection or bond between two or more people.
- Health is the state of complete physical, mental, and social well-being, while wellness is the active process of achieving it. Wellness has six dimensions: physical, intellectual, emotional, environmental, social, and spiritual.
- Purpose refers to having a definite vision and goal and being determined to achieve it. It is your “why” for life.
- Being grateful is a positive emotion that entails focusing your time and attention on what you appreciate. The intent is not to block out difficulties but to approach those difficulties from a different perspective.
- Being mindful is a state of active, open attention to the present moment. It involves observing one’s thoughts and feelings without judging them as good or bad.
- Learning is acquiring new knowledge, skills, and behaviors through experience, observation, and reading. It is a relatively lasting change in perspective and behavior resulting from experience, observation, and reading.
Reference:
- Psyche Wizard
Free Cash Flow Yield
Key variable: free cash flow yield.
Free cash flow (FCF) is one of the most important financial metrics you can study – especially if you’re a buy-and-hold investor. Free cash flow is the amount of money generated from a company’s operations minus any capital expenditures; it is the cash remaining after a company has paid its expenses, interest on debt, taxes, and long-term investments to grow its business.
Suppose a company generates more cash than it needs to run its business. In that case, it can do several valuable things, such as pay dividends, buy back its stock, acquire other companies, expand its business, and knock out its debts.
Free cash flow yield is thus free cash flow per share divided by the stock’s price.
By looking at operating earnings, free cash flow takes out one-time gains or losses that may obscure the actual state of a company’s business. It’s also less susceptible to the accounting gimmicks impacting a company’s reported earnings.
Many of the greatest investors consider free cash flow yield a key factor in analyzing a stock. There are limitations to any single metric, and free cash flow per share and free cash flow yield are no exceptions to that rule.
A company, for example, can have an extremely high free cash flow in part because it is putting off necessary capital expenditures. Similarly, a good company that makes significant capital investments one year may see its free cash flow take a hit but may benefit over the longer haul. That’s why it’s important to consider free cash flow along with a stock’s other fundamentals.
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