3 Simple Tricks to Ensure Your Investments Grow Over Time
3 Simple Tricks to Ensure Your Investments Grow Over Time
Today, I will discuss the importance of focusing on the intrinsic value of a business for maximal upside, with specific attention given to three easy to find metrics
If you ever have the hope of capturing the maximal upside of a stock, your focus should be on monitoring the intrinsic value of your holdings.
If you hope to take advantage of holding a compounding stock for long time periods, you need to make sure that the business is actually improving. If you buy Chevron and are hoping to hold it for the next 10-20 years, you better be watching it to make sure that its intrinsic value (IV) is improving at a reasonable rate.
A simple problem many investors face is that they:
Focus on the stock price over everything else
Don’t know how to tell if the IV is increasing
So let’s go over 3 different ways that you can measure the direction of a businesses IV.
Earnings Per Share (EPS)
Earnings are the essence of business.
Any business owner wants to see a growing top and bottom line. In the case of EPS, we are talking just about the bottom line. And… We are talking about per-share increases in earnings.
Some acquisitive businesses can boost their earnings over the short term by purchasing another business.
They get to include the earnings of the acquired business on their financial statements. Often these acquired earnings do nothing to boost the per-share value of the business. Let’s go over how this could theoretically happen.
Company A wants to purchase Company B.
Company A has the following:
Earnings: $100,000
Shares outstanding: 100,000
EPS: $1
Market Cap: $1M
Cash: $0
Company B has the following:
Earnings: $100,000
Shares outstanding: 100,000
EPS: $1
Market Cap: $1M
Cash: $0
They are mirrors of each other. The thing is, Company A has no cash to use to purchase Company B. So Company A structures the deal so they issue stock in order to purchase Company B. They issue 100,000 additional shares.
Here is Company A after the acquisition:
Earnings $200,000
Shares outstanding: 200,000
EPS: $1
Market Cap: $2M
Cash: $0
To the naked eye, the acquisition might look attractive. After all the business just doubled its earnings. But we don’t own the entire business, we own shares of the business. The deal did nothing to improve value for shareholders.
EPS is still $1!
But you may see press releases from the company touting how the acquisition will “instantly improve the value of the company by bringing in additional earnings.”
But as you can see, this is b***s**t.
The only true value this acquisition had was padding management bonuses…
We’ll go over how an acquisition should be done in the next section.
Free Cash Flow (FCF)
Free cash flow is the true cash that the business produces for it’s owner.
Earnings are great, but they can be obfuscated by accounting standards. FCF shows us how much cash the underlying business is creating, then removes capital expenditures from the equation. If you fully owned the business and we pretended that it was private, FCF would be a better presentation of the cash you would receive from owning the business.
Buffett loves this metric because it helps him:
Find businesses with a moat
Use the excess money to do value-accretive actions
Pay him a dividend
These are all features that I’d love as well. I don’t care much about dividends, but as a capital allocator, I’m fine receiving them as long as it makes sense for the business to pay them.
Just like a business can make poor acquisitions based on earnings, a business can do the same thing on FCF. This is rare, however, as management usually isn’t earning incentives based on FCF.
But let’s use the same example above and replace EPS with FCF.
Company A has the following:
FCF: $100,000
Shares outstanding: 100,000
FCF/Share: $1
Market Cap: $1M
Cash: $1,000,000
Company B has the following:
FCF: $100,000
Shares outstanding: 100,000
FCF/Share: $1
Market Cap: $1M
Cash: $0
Now, we see Company A has a million dollars in cash. They use this cash to purchase Company B. Here is what Company A looks like now:
FCF: $200,000
Shares outstanding: 100,000
FCF/Share: $2
Market Cap: $2M
Cash: $0
You can see that this deal was massively value accretive for Company A. This is an overly simplistic example, but I think you get the point. When a business can use its own cash rather than equity to purchase another business, you’ll generally see more value go to the acquirer.
There is a third vehicle for purchasing a business, bank debt, that we didn’t go over.
We’ll cover that in the final part of this write-up.
Returns On Invested Capital (ROIC)
Returns on invested capital are a metric that needs to stay above your threshold.
What do I mean by this? The beauty about ROIC, is that it doesn’t need to necessarily increase in order for your business to be getting better. A business that can maintain 15% ROIC for 20 years is an incredible business. A business with a ROIC that fluctuates wildly is not something that interests me.
If a business has a ROIC of 50% one year then it drops to negative the next, it’s not giving me useful data about whether the business is maintaining its competitive advantages.
Let’s look at some examples. We’ll start with Coca-Cola, a business that has one of the best brand moats on the earth. We can see the business has an ROIC that rarely drops below 15%. This is what I like to see.
Next, we’ll look at a business that you know I like: Aritzia.
This business is a little more complicated and requires understanding a few things. The drops in 2017 and 2020 were what I’d consider one-off issues that have a low probability of happening again. If you remove those from the equation you see the numbers are steadily improving and are well above my 15% threshold.
Next, we’ll look at another business I own: Alibaba.
You can see from the chart below that Alibaba has had a decreasing ROIC. If I knew then what I know now, I wouldn’t have bought Alibaba.
But I won’t get into the details of that investment today. As you can see its ROIC has steadily gone down and has been above my benchmark only once since 2015.
A declining ROIC indicates that the business's moat is being eroded. This is pretty common in the world of business. When competitors see other businesses with high returns on capital, they pour more capital into those industries. As the industry gets saturated with capital, the ROIC will revert down to the mean.
What you really want to see is a business where ROIC is either:
Steadily improving.
Or
Consistently above your threshold.
A great example of a business like this is $EVVTY. They’ve had consistently high ROIC (the drop had to do with a massive influx of equity from an acquisition). And as you can see, it’s steadily rising again. We probably won’t see above 50% again, but as long as they are staying in the high teens and early 20s I’ll be a happy shareholder.
So here is what you should be doing if you are hoping to capture maximal upside from a specific stock.
Track all three of these metrics in unison.
Monitor for steadily increasing EPS and FCF. Any massive disruptions to growth rates need to be rationally explained. Don’t give up on a business because it had one bad outlier year. Try and find out what happened, and if the event is likely to happen again.
Watch ROIC and make sure the rate is staying above your hurdle rate. If it drops below, find out if it’s a one-off event and if the number is likely to go back up to your hurdle rate.
When you watch these three actions what will happen is that you’ll understand the business much better. You’ll be able to identify if a business is going through temporary headwinds or secular declines. You’ll be able to exit investments that will not offer you your intended returns. You’ll have the conviction to hold on to great businesses that are going through tough times (and be bold enough to add to your position if the price is right).
If you can accomplish all these goals over a lifetime, you’ll have some massive winners to help carry your portfolio into retirement!
Thank you for the list Kyle!