Sunday, September 6, 2015

Look for businesses where ROIC >> WACC; Be wary of market when q ratio >> 0.7

"The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share."

- 1979 Berkshire Hathaway Annual Report

I was reminded of the above quotation when I read the Universa Working White Paper The Dao of Corporate Finance, Q Ratios, and Stock Market Crashes.

The paper states that the most important metric for an individual business is ROIC verses WACC.  Competitive forces make ROIC approximately equal to WACC for most business (about 8%) and therefore growth rate doesn't matter for most business.  Look for businesses where ROIC >> WACC.

Theoretically, aggregate EV/BV (Tobin's q ratio) should be approximately equal to aggregate ROIC/WACC which should be about 1.  Historically, the q ratio averages about 0.7 due ostensibly to book values being systematically overstated.  Be wary of market conditions where q ratio is >> 0.7 (currently at 1.02).

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