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Welcome to the Investing Section of Options Realm |
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In my previous article entitled What Goes Into Valuing A Stock I mentioned that I that I would continue with another article about how important ROIC and growth are when valuing a stock. I will start with why growth is very important when you are figuring out what the fair value of a stock is. In order to display why growth is important I will us an example which displays how important compounding is and why growth of profits changes the value of a company. Lets say that we have a company that makes 100 dollars in profits this year and is expected to grow profits at a 5% rate over the next 5 years. After 5 years the company will be making 127.63 per year. Now lets do this experiment again and say the company is still making 100 dollars a year and will grow at 10% a year. Now after the 5th year the profits are $161.05 instead of $127.63 which is a difference of $33.42 but while this difference is important the more important fact is that the company would make $580.19 in total profits over the 5 years with a 5% growth rate versus $671.56 in total profits from the past 5 years with a 10% growth rate. This is a huge difference and because of this the company is worth more with the 10% growth rates. Now that I touched on why growth is so important I am going to move on to Return On Invested Capital and why an investor should look at ROIC. If a coal company decides that it wants to expand by buying more coal mines then it is going to have to invest money. Say the coal company buys a mine for 100 dollars and the next year the company makes a $25 profit then the ROIC on the 100 dollars invested is 25%. The important part of ROIC is that it measures how efficiently the company is using its funds in order to further expand the company. |
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