David Milstead of the Globe and Mail recently wrote a column which was called How to separate wealth creators from wealth destroyers. As long term buyers, you want your wealth to grow rather than slowly erode and that is why this column was wrote. Often times the easy metrics are used because they are easy to do. However, Mr. Milstead was reviewing information about companies that have the best return on capital, versus their capital cost. His question was which companies have the worst return on capital versus their capital cost? If you know which ones are the worst, then you can avoid them, unless there is really really good reason. Maybe they are a mining company and the commodity price is low, but if you took a 5 year average it might be better picture If you avoid the worst, then you can be better on the markets. Any company that is losing money is not earning more than its cost of capital.

The other strategy is to find out which companies have a really low capital cost that allows them flexibility and even if they just do relatively normal and they will do well. Those companies have a built in advantage. Remember companies make money through its investments or its return on invested capital needs to be greater than their cost of capital.

To create a high economic performance – divide the companies’ return on capital by their cost of capital. or Return on capital equals net operating profit after tax (NOPAT).

The cost of capital is cost of debt plus equity. The debt is the interest rates the company pays plus an assumed cost of the equity a company issues. The result is called Weighted Average Cost of Capital or WACC. Companies do not disclose the number so analysts have to determine it which means sometimes is more art than science.

Linking to dividend paying companies, one of the great advantages of companies which consistently making profits is the ability to raise capital by issuing debt or shares at low cost. If things are normal in the marketplace they will continue to do well. If you buy a company which has a high cost of capital they have to make an even higher cost of return to be make money, which is a risk. It can be well worth it but if one thing goes wrong, then with the high cost of capital, you will likely lose money. The strategy is then to find companies will a low cost of capital and make the most of those investments it is making.

There are more questions than answers, till the next time – to raising questions.