Return on capital

The balance sheet is where this gets really interesting.

Because management has been incredibly vocal in these latest filings about their obsession with return on invested capital or ROIC.

They are explicitly targeting an ROIC of over 10 percent.

And to put that 10% target into perspective, we have to look at their weighted average cost of capital, their WACC.

Currently, it sits at 4.8%.

Okay, 4.8%.

Meanwhile, their actual ROIC is currently sitting at 6.8%.

OK,

And then Tim, also a strategy advisor, but from a different lens, from a McKinsey lens, he was looking at, because his job is to look at return on implied capital, implied attention, implied resources.

So ROIC advisor, I called him.

and it's Tim right and so Tim says no Jay before according to my method before we introduce any new product we have to have a hundred percent optimized and scaled existing products because otherwise the ROI is too low so you solved something but you created a different problem And that's, you see why you want a board of advisors? Because the amount of time that I would have to think about this is enormous.

And they just did it in half an hour while I drink my coffee.

One of the most common questions is: What kind of return on invested capital can these companies earn from all of these trillions of dollars of data center infrastructure investment? Well, our bottom-up work points to encouraging answers to this question.

We see paths to roughly twenty-five to fifty percent return on invested capital, or ROIC, across three emerging AI business models.

Now, ROIC is a useful way of measuring whether investments pay off.

Think of it as how much after-tax operating profit can be generated relative to the capital required in the first place.

The first business model we've analyzed is renting compute power.

Any other questions on cost of capital?

Now the other part of this problem did ask for a return on capital and I'm going to very quickly go through this simply because this is something you did do on your company when you looked at does it have good projects.

Now I want to talk a little bit about mechanics.

This is the only place, absolute only place in finance where we use book values.

Book value of equity, book value of debt because invested capital is a book value number.

So usually the measure of return on capital is after tax operating income divided by book value of invested capital.

So let's see what that number looks like.

My operating income, if I forget all about the leases, I work just with the traditional accounting statements, is 40 million.

"While comparing company stocks, are there metrics that speak to the underlying structure of a business which potentially might suggest how much they would return to their investors over time? For example, Coca-Cola has higher return on invested capital than S&P Global and WM, but it hasn't returned nearly as much historically with dividends reinvested.

So I don't know if ROIC is the right metric to monitor, or if I should compare these businesses at all since they are in separate sectors.

But to include one in my portfolio, I need to make assumptions about how much my money would grow if I had invested in each of them.

Thanks for the amazing content.

Please keep doing the same forever." Okay.

Matt, this is essentially a question about ROIC or return on invested capital and, you know, is this the, the magic bullet that we need to screen for to find the stocks that are going to make us money over the long term?

I mean, first of all, I don't think you'll go wrong with any of these capital efficient businesses that you, that you mentioned.

Um, but, uh, you know, ROIC, it's only one piece of the puzzle.

Yeah.

And their return on invested capital, ROIC, dropped to just 3.0%.

For our listeners focused on capital allocation, those numbers are a really tough pill to swallow.

They are.

I

mean, an ROIC of 3.0% means they are barely out earning their cost of capital.

They're taking shareholder money, investing it into the business and generating a return that you could almost beat with a standard government bond.

Exactly.