One common flaw that many investors have is an inability to view their stocks as partial ownership in a real, living, breathing business. This tendency leads many of us to impulsively screen stocks based on charts, formulas, and ratios. But is that how we’d really judge a company’s performance if we were the owner?
Of course not. That’s why I suggest that all investors do their best to view a stock as an actual business that they hold part ownership in. The tricky part, naturally, is to figure out what makes a successful business.
Plotting the right course
So much is made of a stock’s price from quarter to quarter, but few investors ever stop to evaluate the business model. Poor business models are the biggest reason that some companies with wonderful products, take Pandora for instance, struggle to earn consistent profits. In the world of business plans, low cost structures rule. If you can have a low cost structure, and a rabid following of devoted customers, that’s even better.
Three businesses that exemplify this wonderful mix of low cost structure and a wonderful customer basis are Starbucks Corporation (NASDAQ:SBUX), Panera Bread Co (NASDAQ:PNRA), and eBay Inc (NASDAQ:EBAY).
To say that these companies, and their stocks, are doing well is beyond obvious. All three companies are trading at multi-year highs, but why?
How has Starbucks Corporation (NASDAQ:SBUX) been able to grow earnings over 15% at its size, and how the heck has eBay Inc (NASDAQ:EBAY) increased EPS a whopping 52% over the past five years? Does it really make sense that Panera Bread Co (NASDAQ:PNRA) has been able to increase in value three times over since 2010, while still trading at a low price to earnings growth ratio of just 1.3? It all makes sense, if you’re looking in the right places.
ROIC: A compass in the search for low cost business models
I’m always amazed at how hard it is to find a company’s return on capital. This metric is not easily or readily found on any major stock screening sites, but it sheds so much light into a business’ health. Return on invested capital measures a company’s return relative to all of the money (debt, salaries, assets, etc.) that is put into a business. In short, it’s exactly how you would measure your performance if you owned a business.
Many companies increase earnings by spending recklessly. A company might pull off a costly acquisition or over-expand stores, even amid declining margins and returns. All of these moves will make earnings per share growth seem wonderful, even if the business is secretly doing much worse.
Which brings us to Starbucks Corporation (NASDAQ:SBUX), Panera Bread Co (NASDAQ:PNRA), and eBay Inc (NASDAQ:EBAY). All three businesses have increased earnings at a meteoric pace. But look at the chart below, the staggering fact is these businesses have earned a higher return on every dollar invested, even as they’ve achieved rapid expansion.
Further to the point, check out the chart below following capital expenditures. It’s quite amazing that as all three of these businesses went into hyper growth, their expenditures actually went down! This definitely confirms that the business’ high returns on capital are that “sweet spot” mix of increased sales, due to happy customers, and low costs.