All things remaining equal, companies with better growth prospects (of earnings) are more valuable than those that have inferior growth prospects. Consider three companies A, B and C. The first two will have earnings growth of 25% for the next 3 years while the third one can grow earnings at 10%. Which one is more valuable? A and B should have a higher value compared to C.
However, focusing solely on earnings growth is a ‘fatal mistake’. Not only should we look at the potential earnings growth, we should also focus on the investment made to get to that growth. If the company has to invest a huge sum of money to get to that 25% earnings growth, it is possible that the company is destroying shareholder value. This is why, investors MUST look at another very important metric called “Return on Invested Capital” (ROIC) which measures what return companies are generating on their investments.
So now between A and B (both of which will see earnings grow by 25%) if A has a ROIC of 30% while B has ROIC of 10%, A is clearly a much more superior company than B. In fact, if B has Cost of Capital (aka WACC) of more than 10% then the company is actually destroying value for its shareholders.
Great investment opportunities have 3 distinct qualities.
a. High ROIC
b. Potential to reinvest capital (thus grow) while keeping ROIC high*
c. Reasonable price compared to intrinsic value
The tricky part is usually part b because if return on capital is high then competitors and new entrants might enter the segment and this will lead to reduced ROIC. Thus a company can only continue to maintain its high ROIC if it has significant barriers to entry like cost advantages, brand premium, network effects, high switching cost etc.
Research by Mckinsey has shown that over the long-term ROIC will converge towards sector medians. The skill of an analyst lies in identifying how long a company can maintain its high returns.