Why is Cash Flow to Assets important?

Return on Invested Capital is a well known metric. Basically, it tries to measure the effectiveness of a company in deploying its capital. 

Let's say you have two companies. Both are exactly equal. In fact, both make an operating profit of 100. There is one difference though. One of them uses machines that only cost 25, while for the other the machines cost 75.

What does mean? Well, the company that can make the same revenues with less investment, can expand way quicker. It can build three factories instead of one. It is more scalable. 

Does Cash Flow to Assets 'work' as a factor?

So is this characteristic important in terms of your future returns? Let's find out. 

Below we see the output of a ranking test, where we rank all companies based on Operating Cash Flow to Assets. You could say that is a very basic way of defining Cash Flow ROIC over the trailing twelve months. 

As you can see, even our basic ranking seems to have some predictive value. Especially on the short end - if you buy companies that have a 'terrible' way of turning their assets into profits, you will end up not doing well.

Another way of representing this is to look at the returns at the end of the period. As you can see, most of the spread in terms of returns is due to the lowest ranking buckets (where the lowest ranking companies are in), show a terrible return.

Should you use Cash Flow to Assets?

Probably.

Return on capital measures should probably be part of any ranking system used in an equity strategy. They are consistent and usually improve returns as well as limit downside risk.

As a characteristic, I recommend basing any ranking system around a few return on capital measures.

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Over the last 5 years I have been making 40%+ returns. Some of my top holdings are NATR, ESP and VLGEA.

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