How to Find Value When Evaluating Investments
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As I've said before, investing money is an art. And evaluating investments effectively is key. There is no specific, cookie cutter method for conducting investment analysis. However, establishing core investing principles and conducting proper research and due diligence in advance of investing will go a long way toward increasing the value of your money investments. Learning how to find value when evaluating investments is key. This will help set the stage for a wealth creation system, allowing you to invest money to make money.
There's at least some amount of risk inherent with any money investment. When you make an investment, you're entrusting your money to someone else with the expectation that they will add value to your investment. That's a big part of the reason why assessing the quality of management upfront is a necessary step in evaluating investments. Not only should management be fully capable and skilled at managing the business or investment, they should also know how to create and measure value. You can save yourself a lot of heartache and angst, giving you ability to rest easy, by knowing how to find value when evaluating investments.
Cost of Capital
When you embark upon an investment strategy, you do so with the expectation of eventually receiving a certain level of return on your investment. Most expectations are set by what could potentially be earned from other investments of comparable or lesser risk. For example, if 30-year U.S. Treasury bonds are hypothetically producing 5% yields at current. You would want to earn at least a 5% annual return on investment for any other money investment, while also considering the fact that treasury bonds are considered "risk-free."
An investor needs to be adequately compensated for the level of risk and the time value of money. You'd rather have that money in your pocket now rather than 30 years from now, right? So, consideration for the time value of having that money invested elsewhere is also something you should expect with investment returns. The rate you require to be paid, considering risk and time value of money, is the cost of capital.
The Twin Towers of Value Creation
Companies primarily operate on two sources of capital: equity and debt. Advanced valuation techniques related to investment analysis will use a weighted calculation for an average return of investor expectations related to both equity and debt. The resulting metric is what's called the WACC (weighted average cost of capital) as the company's cost of capital.
In turn, value is created by companies investing capital (both equity and long-term debt) from investors to generate future cash flows at rates of return in excess of the cost of capital. Most large companies have a cost of capital between 8 and 10 percent. Without getting too technical or advanced, again, your cost of capital is the rate at which you expect to get paid considering risk and time value of money. A quick and easy way to establish your cost of capital is simply the rate of return you could receive from other investments of comparable risk.
So, a company with rates of return on invested capital (ROIC) that exceed its cost of capital is creating value. That's the first tower of value creation. The other tower is the level at which companies can grow their revenues (and earnings) and deploy more capital at attractive rates of return. The twin towers of growth and return on invested capital (ROIC) are the underlying drivers of value and value creation. Focus well on these metrics when evaluating investments.
While growth is indeed one of the twin towers of value creation, it's important to note that not all growth is good growth. As previously asserted, a company must be at least profitable to even be considered a worthwhile investment. If it's not profitable, with no proven and successful operating history, I don't believe it's worth investing in.
Profit is the essential part of ROIC driving that metric. There must be profit to establish a ROIC in the first place. And within the combination of ROIC and growth as the twin towers of value creation, it's also critical to note that ROIC must exceed the cost of capital. A company that is profitable and growing without its ROIC covering the cost of capital is actually destroying value.
Growth is a key measure of performance, but it's just one aspect of value creation. On its own, it doesn't reflect the critical importance of capital productivity. If comparing two companies within the same industry with the same level of returns, earnings growth would be the differentiating factor. However, returns can vary considerably across companies within the same industry. According to research at McKinsey & Co., for any level of growth, value always increases with improvements in ROIC. But the same is not true of growth. When ROIC is high, higher growth increases value, but when ROIC is low, higher growth destroys value.
As a starting point for finding value when conducting investment analysis, focus on return on invested capital (ROIC) and growth. This a big part of how to find value when evaluating investments. Obviously, there are a number of other aspects of a company that are necessary to research in advance of investing, but a company with high ROIC and decent levels of growth is likely a solid candidate. In contrast, a company with low ROIC is likely one with a flawed business model or one operating within an undesirable industry structure. So, focus on decent levels of growth and high ROIC, with return on invested capital (ROIC) being the more important of the two.
In sum, identifying companies for investment that are truly creating value will allow you as an investor to achieve adequate returns. Regardless of short-term stock market performance, such a company will ultimately command a higher price in the market if it is consistently generating value.
The information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions. I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP. The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.
 Koller, Tim, et al. “The Core of Value.” The Four Cornerstones of Corporate Finance, John Wiley & Sons, Inc, Hoboken, New Jersey, 2011.