Andrew and Dave recently hosted Braden Dennis on the Investing for Beginners Podcast, and Braden gave us a peek behind the curtain into two of his favorite high ROIC stocks right now.
If you haven’t heard of Braden Dennis, then you’re likely new to the Investing for Beginners Podcast, because he is a reoccurring guest and for very good reason…give the episode a listen and you’ll understand why!
Braden is the Principal at Stratosphere Investing and has a ton of awesome content that is worth your time to check out – my favorite recent post of his is one where he outlines 5 Questions to Answer Before Buying a stock in the 2020 Bear Market.
In short, Braden is a trustworthy source of information, and when he came on the podcast he was willing to share two stock picks that he loves right now that have a very high ROIC, and I am particularly excited to write about them, because I might just happen to share the same opinion ?
But first, what is ROIC?
I’ll give you a high-level, birds-eye view type of look at ROIC as a general understanding, but Dave went really in-depth with a ROIC post that I highly recommend you look at. It was very helpful for me and I know it will be for you as well
Well, ROIC stands for Return on Invested Capital. WallStreetMojo defines it as “ROIC Formula (Return on Invested Capital) is considered as profitability and a performance ratio and is calculated based on the total cost and the return generated, returns are the total net operating profit after tax while investments are calculated by subtracting all the current liabilities from its assets.”
In layman’s terms, it’s essentially how competent the management of the company is. You’re trying to find out just how effective and efficient that the company is in utilizing their capital to create future earnings. The higher the ratio, the more efficient that the company is in utilizing their capital.
So how do you calculate it?
So, let’s pretend that a company makes $1 million in Net Operating Profit After Tax, but they invested $5 million. In that case, their ROIC is 20% ($1 million / $5 million).
Is that good? Well, it all depends on their Weighted Average Cost of Capital (WACC).
“Ugh, ok, so what is WACC, Andy?”
WACC is what I am after four weeks of working from home while being quarantined…get it…like wack? No?
Ok, cool. Hook em!
I know I went off the rails just now but that’s a bit of an inside joke for any of my college football fans out there…man, I hope we get football this year.
OK – BACK TO ROIC AND WACC!
WACC is basically the cost that the company has to pay for their capital. In essence, if the WACC is 8%, then the company should have to make at least an 8% return simply to breakeven. The full formula, per WallStreetMojo, is below:
So, ROIC and WACC are used in tandem. Your formula should really be ROIC – WACC = Total Return. Which of the two companies would you rather be invested in?
Company A – 25% ROIC with a 12% WACC
Company B – 20% ROIC with a 5% WACC?
I’d prefer Company B, because the Total Return is 15% (20% – 5%) vs the Total Return for Company A of 13% (25% – 12%).
Essentially, you’re trying to see what company is outperforming their costs by the most.
So, what stocks did Braden actually recommend?
My personal favorite stock, Visa, and Mastercard!
The best tool that I use to look at ROIC and WACC for a quick look, without having to do the calculations, is with gurufocus. Now with gurufocus, you have to pay for a subscription, and it’s not cheap, but a workaround is to simply google the stock and then ROIC after it, so like ‘Visa ROIC’ and then click on the link:
When you do this, you’ll get to the following page which then will tell you about the company’s ROIC and their WACC:
As you can see, in this case with Visa, their ROIC is 32.28% and the WACC is 6.24%, so a total return of 26.04%. I did the same thing with Mastercard as well:
As you can see, their ROIC is much higher at 120.51% and their WACC is 7.41%, meaning their total return is 113.10%, wayyyy over Visa’s total return.
If you scroll down a little bit more, you can see a chart that shows the ROIC comparisons vs. the peers:
Mastercard is way above the rest, with Visa coming in right behind them. It’s important to note that this is only the ROIC numbers and doesn’t include the WACC comparison, so you should always look at that when doing it yourself.
Personally, I think that ROIC is a great ratio because it tells me two major things:
How effective is the company with their money?
In a roundabout way, this is telling me about the management of the company. If they’re not continuing to grow their earnings with retained earnings, then I likely won’t be a big believer of them for the coming future.
Are they generating enough future earnings or are they ineffective with their money? If their ROIC is strong enough, then I don’t want them to be paying out some crazy dividend.
GASP! I know, I know. I love dividends…like a lot, a lot. Yes, dividends are great, but if you’re telling me that Mastercard can gain a better than a 1:1 ratio of their future earnings by retaining some cash, why wouldn’t I want that? I want them to keep on keeping on and growing into a bigger, badder player than they are right now.
ROIC was never really a metric that I thought about much until recently, and I think that listening to the podcast episode and reading Dave’s post really helped to put it into perspective for me.
We always hear about the importance of finding a company with a great management team – I think this is a metric that can show you one side of just how effective, or ineffective, that they might be!