Latest / Stock Picking with Fexingo: Individual Equities, Research, and Building a Concentrated Portfolio / How to Use Cash Flow Return on Invested Capital for Stock Picks
Transcript
- Lucas: Luna, I have a question for you. When you look at a stock, what's the first number you check — price to earnings, revenue growth, something else? Luna: I usually start with free cash flow yield. P/E can be misleading if earnings are propped up by accounting adjustments. Lucas: Exactly. And that's why I want to talk about a metric that combines the best of both — cash flow and capital efficiency. It's called Cash Flow Return on Invested Capital, or CROIC. Say that five times fast. Luna: CROIC. I've heard it, but I don't think most retail investors use it. Why should they? Lucas: Because it tells you how much cash a company generates for every dollar of capital it has tied up in the business. The formula is free cash flow divided by total invested capital. A CROIC above 10 percent is generally strong. Above 20 percent is exceptional. And in a market where the S&P 500 is at 7,497 — up almost 2 percent in just the last five days — you need a filter that cuts through the noise. Luna: So it's like a cash-on-cash return for the whole business. I can see why that would be useful right now, with small caps having their best first half in 35 years. A lot of those companies are capital-intensive. Lucas: Right. And that's the nuance. CROIC naturally favors asset-light businesses. A software company with high margins and low capital expenditure can have a CROIC of 40 percent or more. A manufacturer might be at 8 percent and still be a great business. You have to compare within sectors. Luna: So how do you adjust for that? Do you just compare each company against its industry median? Lucas: That's one approach. Another is to look at the trend over time. If a company's CROIC is improving year over year, that suggests management is getting more efficient at deploying capital. If it's declining, even from a high base, that's a red flag. Let's take a real example. Apple, ticker symbol a a p l, trades at $288.73 — down 1.5 percent over the past five days. Its CROIC has been consistently above 30 percent for years. That's elite. Luna: But Apple's revenue growth has slowed. The stock is down this week. Does CROIC catch that? Lucas: It does, indirectly. If Apple's free cash flow starts to shrink relative to its invested capital, the CROIC drops. That would be a warning that the cash generation machine is losing efficiency. For now, it's still stellar. Now compare that to a company like Microsoft, ticker symbol M-S-F-T, at $372.62, up 2 percent in five days. Microsoft's CROIC is also high — around 25 percent — but it's been trending down slightly as they pour capital into cloud infrastructure and AI. Luna: So Microsoft is investing for growth, which lowers CROIC in the short term. That could be fine if the investments pay off. Lucas: Exactly. CROIC isn't a standalone verdict. It's a diagnostic tool. If you see a company with a declining CROIC and no clear catalyst for improvement, that's a problem. But if the decline is tied to a deliberate capital expenditure program, you need to assess the potential return on those new investments. Luna: Let's talk about Alphabet, ticker symbol g o o g l. It's up 3.6 percent in five days, trading at $357.88. How does its CROIC look? Lucas: Alphabet's CROIC has been solid, in the mid-20s. But it's been volatile because their free cash flow swings with advertising revenue and capital expenditure on data centers. One quarter it might be 28 percent, the next 22 percent. That's why I prefer to use a trailing twelve-month average. Luna: That makes sense. Smooth out the noise. So if a listener wants to start using CROIC, where do they find the data? Lucas: You can calculate it from the cash flow statement and balance sheet. Invested capital is total assets minus cash and equivalents minus non-interest-bearing current liabilities. Or you can use a site like Morningstar or Simply Wall St that pre-calculates it. But I recommend running the numbers yourself at least once to understand what goes into it. Luna: And a high CROIC doesn't mean the stock is cheap. It could be priced for perfection. Lucas: Right. That's the other side of the coin. CROIC tells you about business quality, not valuation. A company with a 30 percent CROIC trading at 40 times earnings might still be a bad investment if growth stalls. But combining high CROIC with a reasonable price to earnings ratio is a powerful combo. Luna: So for a stock picker in this market — with the Nasdaq up 2.8 percent in five days and megacap tech still commanding a huge premium — CROIC helps you avoid the pretenders. Lucas: Exactly. And speaking of avoiding pretenders, I want to mention something that keeps our research independent. This show is ad-free, and it stays that way because of listener support. If you've gotten value from our conversations, a couple of dollars a month genuinely makes a difference. You can find us at buy me a coffee dot com slash fexingo. No pressure — just if it's helped you think about a decision differently. Luna: It really does. And we appreciate every bit of it. Lucas: So back to CROIC. Let's talk about how to apply it to a diversified portfolio. If you're building a concentrated portfolio of 15 to 20 stocks, you want a mix of high croic compounders and lower croic turnaround stories where you see a catalyst for improvement. Luna: Can you give an example of a lower croic company that might be worth a look? Lucas: Sure. Consider a company like Ford. It's capital-intensive, so its CROIC might be in the single digits. But if they're launching a new electric vehicle platform that could improve returns over three to five years, the CROIC trajectory matters more than the current level. You're betting on the inflection. Luna: That's a different risk profile. You need a longer time horizon and a lot of conviction. Lucas: Exactly. And that's where active stock picking shines. Index funds can't make those judgments. They have to own everything. But if you're willing to do the work, CROIC gives you a framework to separate the wheat from the chaff. Luna: Final question: What's one CROIC number that would make you immediately interested in a stock? Lucas: If I see a company with a CROIC above 20 percent and a price to earnings ratio below 20, I'm digging deeper. That combination is rare, but when it appears, it's often a signal that the market is undervaluing the business's cash generation. For example, some mid-cap tech companies with sticky subscription revenue fit that profile. Luna: So CROIC is basically a quality filter. Use it to narrow the universe, then do the deep dive. Lucas: Exactly. And in a market that's hitting new highs, having a systematic filter is your best defense against overpaying for hype. Luna: Alright, I'm going to run CROIC on my portfolio this weekend. Thanks, Lucas. Lucas: Happy to. And if you find anything interesting, bring it to the show.