Thursday, July 3, 2008

It's got profits! But is it profitable?

Let's say Company A and Company B both make $1000 / year, and have been growing their profits at 10% per year. Company A and Company B are in the same industry and are similar, except for the fact that Company A has assets worth $500, while Company B has assets of $2000. Assuming they were selling for the same price, which company would you rather own?

It may seem like Company B is more desirable. After all, who wouldn't want to own $2000 worth of assets rather than $500? But actually, if you believe in the growth prospects of this industry, Company A is the better investment! It comes down to "return on assets" (which is sometimes substituted for it's cousin, return on invested capital), which is a measure of what kind of return an investor gets on his money.

For each dollar Company A invests in its assets, it gets $2 in earnings, while Company B only manages 50 cents. If these companies were to grow their earnings by $100 this year, the owner of Company A would only have to invest $50 for that return. On the other hand, the owner of Company B would have to invest $200, which eats up quite a chunk of his $1000 profit.

All too often, investors see growth in a company's future, but fail to consider the costs of that growth. All companies require investments in assets in order to support growth, whether it's in the form of fixed assets, accounts receivable or inventory. The companies with the best return on assets (or return on invested capital) are the ones that reward their investors with cash, not just paper profits.


Anonymous said...

I also like return on equity, which is a more focused metric on the return management is able to achieve with the money that belongs to shareholders. Breaking down ROE using the Dupont Method, it's also possible to see whether management is using debt to the benefit of shareholders.

Saj Karsan said...

Good point, Charles. I tend to prefer companies with low amounts of debt though. My worry is that many companies need to leverage up to have half decent returns, which is why I want to make sure the ROA is good, so that I know the company is in a good business.