Tuesday, June 23, 2009

It's About Returns, Not Profits

All too often, the media is concerned with a company's absolute profit level in determining how successful a company is. However, what's more important is the company's return on its invested capital, since that has a stronger effect on:

1) The cash flows to the shareholder, and
2) Whether the company has opportunities to grow going forward.

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 $5000, while Company B has assets of $20,000. 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 $20,000 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 $0.20 in earnings, while Company B only manages $0.05. If these companies were to grow their earnings by $100 this year, the owner of Company A would only have to invest $500 for that return, allowing the remaining amount to be paid as a dividend or to repurchase shares. On the other hand, the owner of Company B would have to invest $2000, which means he won't see any of that $1000 profit from last year, and the company would need further financing such as bank loans.

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, working capital, or the acquisition of other firms. 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 really enjoyed today's post. Thanks.

Just one question though. Isn't it important to look past the value of assets into their quality, value on resale, et? Do you believe that the depreciated cost of the assets tells the whole story, or do you, when looking at financial statements, consider what the (larger) assets are to get a more fair determination of return on assets?

My own opinion is that "GAAP" depreciation makes ROA assessments less meaningful than they would be if the measurement of depreciation were less arbitrary and more informative.

Anonymous said...

Yes, Greenblatt's "The Little Book that beats the market" stresses the RoIC in the appendix with a beautiful example.


Saj Karsan said...

Hi Anon,

I agree: before performing the calculation, make adjustments such that certain assets (e.g. land) better reflect their true worth.

Anonymous said...

Would you mind clarifying the definition you use for RoIC? I understand the concept, but have a difficult time understanding how people come up with their numbers.

Saj Karsan said...

Hi Anon,

Debt+Equity is usually used as the numerator, since that is what has been 'invested' by stakeholders.

The numerator often used is EBIT*(1-taxrate), which is what net income would be if no capital charges are taken.

There are variants of the formula though, depending on user preference.