Is the company profitable? If not, is it expected to emerge?
You allocate capital to make a return on it. This is applicable to any business irrespective of size. Let’s say someone selling food on a cart, this applies, to how much money he puts in and how much he takes back home. Each company has the objective to optimize the return on the capital that it is investing.
In recent times we have also seen that there is a trend that a lot of companies don’t make a lot of money because they are expected to create a new market. Eventually, they can increase the price and make money. Recently a lot of new-age technology firms got listed in India say PAYTM, Zomato, etc. It is hard to understand the value of these companies however there is a certain segment of investors who may feel that these firms will create a certain market and at that point return on invested capital will. Turn positive.
Whether the company is making a profit today or is expected to generate profit in the future, the bottom is that in order to survive, the company must be profitable.
So you need to look at two sets of things one, the return is greater than the cost – if you are looking at a financial company you need to look at the return on equity and you need to compare it with the cost of equity. Similarly, if you’re looking at non-financial companies, you can look at the return on invested capital and compare it with the cost of capital. As far as the return is more than the cost there is a probability that the company will create value. Ideally, you should be looking at a return on investment of more than 15%. This means every year a company grows its capital by at least 15%.
Warren Buffett divides the companies into three categories, get, good and gruesome. A great company has a competitive advantage for a long time that protects its return on invested capital. It can be due to a very powerful brand or being a low-cost producer.
Great companies often tend to grow slower than other companies. The key aspect of the growth the company achieves is by consuming very little additional capital. Look at Nestle, which is over 80% ROIC every year, requires minimal capital, and yet generates massive cash flows.
A good company grows at a healthy rate that needs a large increase in capital to sustain growth. Like great companies, these companies also enjoy a competitive advantage and make healthy profits. However, good companies, need to reinvest a significant portion of their profits into growth. These companies tend to have returns relatively lower than great companies. HDFC Bank, and Havells India, are a few examples of good companies.
Gruesome companies are those companies that generate very little return on investment capital and require significant capital for growth. Most of the telecom companies will fall into this bucket.
We need to avoid investing in gruesome companies.