Be wary of using Return on Capital (ROC)
Superb companies produce a very high return on capital. But when substantial intangible assets don’t show up on balance sheets, the ROC numbers are unduly flattering to management.
Superb companies produce a very high return on capital. But when substantial intangible assets don’t show up on balance sheets, the ROC numbers are unduly flattering to management.
Most analysts will talk of EBITDA, EBIT, NOPAT and what not. Warren Buffett’s approach is to think in terms of Owner Earnings. It is somewhat akin to free cash flow.
The best cash flow measure is Warren Buffett’s Owner Earnings. If that is increasing faster than GDP, the fair value of companies will increase faster than GDP
From its growing operating cash flow, it is able to fund growing capital spending and also fund growing R&D expenditures. Of note, it seems to be able to maintain and even improve its operating margins. It is easily able to fund the capex needed to maintain it long-term competitive position in its various markets. It is also easily able to fund the capex it chooses to make to grow the company and fund healthy R&D expenditures.
A high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a ‘value’ purchase.
Declining free cash flow may be a sign the company is investing for the future! Or it may be a very bad sign. Increasing free cash flow may be a good sign or a bad sign. It’s all in the interpretation of the financials.
To understand how a company can lose $256 million in reported earnings in 2020 and yet show FCF that year of $491 million you need to read and understand the company’s cash flow statement.
Accounting is but an aid to business thinking, never a substitute for it
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
Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes
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