Welcome to the Investing For Beginners Podcast! In this episode, we have a special guest, John Rotonti, who shares valuable insights on the importance of Return on Invested Capital (ROIC) in determining the intrinsic value and growth potential of a company.
John explains that if the ROIC is higher than the cost of capital, it leads to growth and increases intrinsic value. If it is equal, growth is neutral, and if it is lower, growth destroys value. He also breaks down the formula for calculating the economic spread or excess return spread, which is ROIC minus the cost of capital.
Throughout the episode, John emphasizes the significance of a high ROIC and a higher economic spread for companies. He highlights how revenue growth, especially organic growth, plays a crucial role in driving intrinsic value growth for companies with a high ROIC higher than the cost of capital.
00:04:49 Thorough research and analysis process for investing.
00:10:08 Watch list, market sell-off, network, investor letters.
00:16:57 Checklist for investing in businesses with tweaks.
00:23:26 Free cash flow yield is the best predictor of future returns, according to multiple studies. To calculate normalized free cash flow, consider factors like cash inflows from selling off businesses. Another method is total shareholder return (TSR), which includes dividend yield and earnings per share growth. Models like discounted cash flow (DCF) and reverse DCF can help estimate fair values. Additionally, analyzing acquisition multiples in the industry can provide insights.
00:35:26 DCF is a discounted cash flow model used to estimate future cash flows. It involves forecasting cash flows over a period of 5-10 years and then projecting them into perpetuity. The value of an asset is determined by the present value of future cash flows, which is calculated through discounting. Three key factors to consider are the size, timing, and riskiness of the cash flows. Building a DCF involves modeling revenue growth, EBIT margins, tax rates, and subtracting reinvestment to determine free cash flows. These cash flows are then discounted using a chosen discount rate. The sum of the present values of these cash flows, along with the terminal value, gives the enterprise value. By subtracting debt and adding cash, the equity value can be determined. Dividing by the number of shares gives the intrinsic value per share. Different scenarios can be explored to determine a range of fair values.
00:46:04 ROIC and free cash flow drive value.
00:51:09 Higher ROIC generates intrinsic value growth through growth.
00:59:01 New Constructs provides accurate financial metrics data.
01:02:11 PE ratios and free cash flow multiples are commonly used by people, but they are often misunderstood. However, understanding the three drivers of the multiple – earnings growth, return on invested capital, and risk – can make them useful. Examples show how different growth rates and cost of capital affect justified PE ratios. As the cost of capital increases, the justified PE ratio decreases. It’s important to understand these drivers to make sense of multiples.
You can find more John here on Twitter @JRogrow
For more insight like this into investing and stock selection for beginners, visit stockmarketpdf.com
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You can find the transcript of today’s show below:
