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Today I'll be sharing the NOPAT Margin metric and how firms with high NOPAT Margins usually outperform the market.

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Today’s issue is brought to you by Masterworks!

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Now for today’s piece:

Unveiling the Strength of NOPAT Margin

Highlights

Introduction

To truly grasp why NOPAT Margin is so powerful, let’s start with the metric it’s derived from: Return On Invested Capital (ROIC).

ROIC is a common metric used by investors to evaluate a firm’s efficiency when allocating capital toward profitable investments.

NOPAT Margin is derived from ROIC and firms with high NOPAT Margins often outperform the overall market.

A few companies that have high NOPAT Margins are Apple, Google, Monster Energy, Visa, and AutoZone, each of which has CRUSHED the market over the past 5 years.

In this issue, we’ll break down ROIC and NOPAT Margins further and see why firms with high NOPAT Margins usually outperform the market.

Understanding ROIC and NOPAT Margin

ROIC is a profitability metric that analyzes how efficiently a firm invests its capital.

Its formula is Revenue/Invested Capital x NOPAT/Revenue.

A firm with a high ROIC is investing its capital wisely, which means it likely won’t need to sell more shares to raise capital.

This is good for shareholders because they’re at less of a risk for dilution and the firm can spend excess capital on dividends and buybacks.

And if the firm’s ROIC number exceeds its Weighted Average Cost of Capital (also known as WACC or the opportunity cost) then the firm creates value for shareholders.

Think of it like this: A firm invests $10,000 and its WACC is 8%. If the firm cash flows $800 per year, its ROIC will equal its WACC and no value is being created (800/0.08 = 10,000).

If the same firm was able to cash flow $1,200 per year, its ROIC would exceed its WACC, thus creating value (1,200/0.08 = 15,000).

NOPAT is the profit generated by a company's operations after accounting for taxes but before considering the financing structure.

What this means is that NOPAT measures the efficiency of a company’s operations, but excludes the tax savings the firm receives from financing. NOPAT also excludes one-time charges or losses from things like acquisitions.

The formula for NOPAT is EBIT x (1 − Tax Rate).

NOPAT Margin is the right side of the ROIC equation: NOPAT divided by Revenue.

This NOPAT Margin provides a measure of a company's profitability relative to its revenue.

Companies with high NOPAT Margins are dubbed “Differentiators” by Michael Mauboussin and Dan Callahan, investment managers and researchers at Morgan Stanley.

They wrote 2 phenomenal articles on the concepts of ROIC and NOPAT Margins, which I’ve linked here and will reference throughout this issue.

I highly encourage you to read them.

Importance of NOPAT Margin in Investing

The NOPAT Margin gives us investors insight into a company's operational efficiency and profitability.

It shows that a company can generate strong profits from its revenue, even after accounting for taxes, a nod to its operational efficiency.

On the other hand, firms with low NOPAT Margins indicate lower profitability and potential challenges in generating profits.

Take General Motors for example.

Its NOPAT Margin in the year 2022 was 6.5. Subsequently, it returned -43.81% over the year 2022.

This does not mean the firm is doomed and will never have good returns for shareholders, however, the road to strong operational profitability might be a long one.

If you’d like to see a video of me calculating the NOPAT Margin for General Motors, check out this video here:

Linking Strong NOPAT Margins to Market Outperformance

Here are the 10-year aggregate NOPAT Margins for the 5 stocks I mentioned in the introduction (taken from the Morgan Stanley paper):

Apple – 25.5

Google – 31.9

Monster Energy – 28.4

Visa – 51.3

AutoZone – 16.0

For comparison, the average firm’s NOPAT Margin over the same span was 10.5.

Now, here are the 5-year returns of each stock (dividends not included):

Apple – 305.29%

Google – 104.18%

Monster Energy – 86.55%

Visa – 68.44%

AutoZone – 249.04%

As a comparison, the S&P500 returned 58.50% over the same 5-year span.

As you can see, companies with high NOPAT Margins have led to outsized returns.

Factors Driving Strong NOPAT Margins

What drives these companies to have such strong NOPAT Margins?

I can offer a few observations:

• Operational Efficiency – These companies have found a way to create high operating margins and/or pay low tax rates

• Pricing Power – A lot of the firms on this list have developed brand loyalty and are able to raise prices to offset any increased costs.

• Competitive Advantages – In addition to pricing power, these firms have limited competitors and have built out strong moats as a result.

  (If you read the Morgan Stanley report, you’ll find that Visa’s competitor MasterCard and AutoZone’s competitor O’Reilly’s also made the high NOPAT Margin list. This suggests that these companies operate in a very efficient industry and they do it well at the individual business level)

The nice thing about investing in companies with high NOPAT Margins is that they’ve shown their adeptness at reinvesting capital efficiently for growth.

If management is able to continue this efficient capital allocation, investors can expect outsized returns for years to come.

Final Thoughts

ROIC and more specifically the NOPAT Margin are powerful metrics for evaluating investments.

Stocks with strong ROIC & NOPAT Margins have historically outperformed the market, making them compelling opportunities for investors.

It's important for investors to consider the sustainability and consistency of a company's ROIC & NOPAT Margin over time, however.

The Morgan Stanley report found that 52% of stocks that start in the highest quintile for ROIC don’t finish in the highest quintile for ROIC just 3 years later.

This underscores just how hard it is for an exceptional company to remain exceptional.

The difference between companies that keep their high ROIC and NOPAT Margins is how wide their moats are, so if you find a company with a high ROIC, high NOPAT Margin, and wide moat, it’s probably best to hold onto those shares.

The results speak for themselves.

I hope you liked this breakdown. If you did, please tell a friend about this newsletter!

Until next time,

Dr. “NOPAT Margin” Dividend

Links And Memes

Here are some of the best things I saw this week:

• A secret CIA mission involving implanting microphones into trained cats to spy on the Soviets.

• Four NASA volunteers have begun simulating what life would be like on Mars, even living in 3-D printed homes!

• A window that can turn into a balcony — as if real estate wasn’t expensive enough already.

And as always, some memes:

Thanks for reading, if you liked this issue please tell a friend!

^{* “Net Return" refers to the annualized internal rate of return net of all fees and costs, calculated from the offering closing date to the date the sale is consummated. IRR may not be indicative of Masterworks paintings not yet sold and past performance is not indicative of future results. See important Regulation A disclosures at masterworks.com/cd.}