How do you know if a company is an “excellent business"? The biggest clue is going to come from the financial statements. You want to look for the return on invested capital. In other words, each company has to spend a certain amount of money to make money. For some firms, such as a steel mill, they may need to invest $100 in plants, factories, and equipment to generate $3 or $4 in profit. A candy and confectionery company, on the other hand, may only need to invest $9 to generate those same after-tax results.
All else being equal, the higher the return on capital, the more actual cash a firm will generate for owners that they can take out and spend on stuff like vacations, additional investments, custom suits, yachts, college educations, or whatever else fits their fancy.
This doesn’t mean that you can’t make a ton of money in a bad business that happens to be super cheap. There are always going to be opportunities that arise because Wall Street isn’t able to see beyond the end of its collective nose. In fact, one of the biggest positions in my personal and business accounts right now is an old-line corporation that earns minuscule returns on capital but is trading at what I estimate to be only 25% of its intrinsic value, conservatively estimated. I also own shares of a certain financial company that has been decimated in the credit crisis but I think has a 99% probability of surviving and returning to many, many times its current share price over the next three to five years. These are special situations; ones that I don’t expect to continue holding indefinitely.
On the other hand, there is a certain small cap food company that is so attractive to me right now due to its sky-high return on invested capital, that I plan on having my own retirement accounts load up on as many shares as prudently possible. Due to the quality of this particular business, there are no plans to ever sell the stake provided the underlying enterprise continues to compound at a satisfactory rate.
Some will argue that a brand name is an important indicator of an excellent business. This is true, but my belief is that if that doesn’t translate into superior returns on capital, the brand name isn’t worth as much as the investor thinks. If it’s truly superior, you’ll see that come through in the financial statements. You know the name Coca-Cola is worth something because you see the mouth-watering returns on equity the firm generates for shareholders. It’s able to use its cachet and translate carbonated sugar water into bottles of profit for the owners.
For a more robust discussion of this concept, read Getting Rich by Investing in an Excellent Business.
All else being equal, the higher the return on capital, the more actual cash a firm will generate for owners that they can take out and spend on stuff like vacations, additional investments, custom suits, yachts, college educations, or whatever else fits their fancy.
This doesn’t mean that you can’t make a ton of money in a bad business that happens to be super cheap. There are always going to be opportunities that arise because Wall Street isn’t able to see beyond the end of its collective nose. In fact, one of the biggest positions in my personal and business accounts right now is an old-line corporation that earns minuscule returns on capital but is trading at what I estimate to be only 25% of its intrinsic value, conservatively estimated. I also own shares of a certain financial company that has been decimated in the credit crisis but I think has a 99% probability of surviving and returning to many, many times its current share price over the next three to five years. These are special situations; ones that I don’t expect to continue holding indefinitely.
On the other hand, there is a certain small cap food company that is so attractive to me right now due to its sky-high return on invested capital, that I plan on having my own retirement accounts load up on as many shares as prudently possible. Due to the quality of this particular business, there are no plans to ever sell the stake provided the underlying enterprise continues to compound at a satisfactory rate.
Some will argue that a brand name is an important indicator of an excellent business. This is true, but my belief is that if that doesn’t translate into superior returns on capital, the brand name isn’t worth as much as the investor thinks. If it’s truly superior, you’ll see that come through in the financial statements. You know the name Coca-Cola is worth something because you see the mouth-watering returns on equity the firm generates for shareholders. It’s able to use its cachet and translate carbonated sugar water into bottles of profit for the owners.
For a more robust discussion of this concept, read Getting Rich by Investing in an Excellent Business.
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