Alvin Lau is an investment analyst at Longview Asset Management Ltd. in Toronto.
What are we looking for?
Growing companies with a history of high returns on invested capital (ROIC) that are also trading at relatively inexpensive valuations. Why? Because the increase in the economic value of a business depends on a combination of its ROIC and growth. We performed a similar screen for Canadian companies a couple of weeks ago. Today, we look at U.S.-based companies.
ROIC is a company's earnings before interest and taxes (EBIT) divided by its invested capital (working capital plus fixed assets). It is a measure of a company's efficiency in allocating its capital to profitable investments. We use EBIT rather than net income in our ROIC calculation, as it allows us to put companies with different levels of debt and tax regimes on equal footing.
The longer a business can sustain an ROIC greater than its cost of capital, and the greater the spread between the two percentages, the more value it will create. A consistently high ROIC is usually indicative of a sustainable competitive advantage, which is what Longview looks for in the companies it owns.
My colleague, Kelly Brown, and I used the S&P Capital IQ Screener to search for U.S. companies with a five-year average ROIC of greater than 15 per cent, and a minimum earnings per share (EPS) growth rate of 10 per cent over the past five years. To increase the chances of finding underpriced companies, we excluded companies that had enterprise value (EV) to EBIT multiples greater than 10. EV is equal to the market value of a company's equity, plus all of its interest-bearing debt, less any excess cash.
We also excluded any company with a market capitalization below $3-billion, a total debt to capital ratio of greater than 50 per cent, and companies in the financial sector, as the value of such companies is best measured by other metrics.
More about S&P Capital IQ
S&P Capital IQ offers tools for fundamental analysis of global securities as well as idea generation and work-flow management. Its Web- and Excel-based platform provides access to information on companies, markets, transactions and people around the world.
What we found
Our screen produced 24 results, from which we selected the 10 companies with the lowest EV/EBIT ratios. Out of this list, CVR Energy, Activision Blizzard and Valmont Industries appear to be interesting investment candidates. But, as always, please do your own research before investing in any of these stocks.