Friday, July 1, 2011

Returns More Important Than 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 $5000? 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.

1 comment:

Taylor said...

Saj,

This post reminds me of Buffett's explanation of economic goodwill. If you haven't already, you should check out Berkshire's 1983 shareholder letter (the appendix). Good stuff!

-Taylor

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