Friday, June 4, 2010

Look At 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.


Dhaka Stock Exchange said...

Thanks for sharing this helpful info!
I always like to read your blog..

Nick Gogerty said...

Well said and a very clear post.

Far too often people forget the basics of return on equity. Investing isn't complicated, its business. It gets complicated when people forget that.

rayhaan said...

yo saj, owner's earnings r definitely in! r their any other ratios or indicators wich help measure this? Wot r ur views on d PEG and cash eps(is ceps really as helpful as hyped by sum analysts?

Saj Karsan said...

Thanks, Dhaka and Nick!

Hi Rayhaan,

I think cash EPS can be useful (with the caveat that it should be looked at over many years, as a single year can tell you very little).

I'm not a huge fan of PEG, as I find the "g" component incredibly subjective and difficult to predict, so if used in isolation it can probably lead to some very poor decisions.

Anonymous said...

Nice post, Saj! ..Maybe a litte example could help me ;-) ..Lets say I would have to choose between to investments ..True Religion Apparel (TRLG) with a ROIC(TTM) of 50% and Joes Jeans (JOEZ) with a ROIC of 10% (TTM), you would favor TRLG even though JOEZ might be a young company with a "growth" story?

Best wishes


Saj Karsan said...

Hi Nell,

I have answered your comment here

Anonymous said...

Hi Saj,

Thanks for your reply! ..It really explains the difference between speculation and investing! ;-) ..So intrinsic value is determined by future returns on capital and not past results ..Growth can be worthless if there is no positive spread between return on capital and cost of capital!

Best wishes,