This is the fifth and last part of the accounting for beginners series. I recommend that you read first  Part IPart IIPart III and Part IV. Again, my main inspiration for this series is Pat Dorsey’s “The five rules for successful stock investing“.

Profitability

How much profit is the company generating relative to the amount of money invested in the business? This is the real key to separating great companies from average ones, because the job of any company is to take money from outside investors and invest it to generate a return. The higher that return, the more attractive the business.

We can talk about profit margins as well as the importance of understanding whether cost cuts or price hikes are driving an increase in profit margins. Comparing cash flow from operations to reported earnings per share is another good way to get a rough idea of a firm’s profitability because cash flow from operations represents real profits.

But neither net margin nor cash flow from operations accounts for the amount of capital that’s tied up in the business, and that’s something we can’t ignore. We need to know how much economic profit a firm is able to generate per dollar of capital employed because it will have more excess profits to reinvest, which will give it an advantage over less-efficient competitors.

Think about it this way – a company’s management is similar to the manager of a mutual fund. A mutual fund manager takes investor’s money and earns a return on it by investing in stocks and bonds. Wouldn’t you rather put your money in an equity manager who has consistently generated returns of 12 percent per year than one who has returned an average of only 9 percent?

Companies aren’t much different. They take shareholder’s money and invest it in their own business to create wealth. By measuring the return that a company’s management has achieved through this investment process, we know how good they are at efficiently transforming capital into profits. Just like a mutual fund, a company whose management is investing well enough to generate returns on capital of 12 percent is usually a more attractive investment than a company that returns only 9 percent on its capital.

Our two tools for assessing corporate profitability are return on capital and free cash flow. I start with return on assets (ROA) and return on equity (ROE), and then I’ll show you how to compare free cash flow to ROE. I’ll finish  up with a quick discussion of a sophisticated measure of profitability called return on invested capital (ROIC).

Return on Assets (ROA)

You already know the first component of ROA. It’s simply the net margin, or net income divided by sales, and it tells us how much of each dollar of sales a company keeps as earnings after paying all the costs of doing business.
The second component is asset turnover, or sales divided by assets, which tells us roughly how efficient a firm is at generating revenue from each dollar of assets. Multiply these two together, and you have return on assets, which is simply the amount of profits that a company is able to generate per dollar of assets.

 

Net Income / Sales = Net Margin

Sales / Assets = Asset Turnover

Net Margin * Asset Turnover = Return on Assets

Think of ROA as a measure of efficiency. Companies with high ROAs are better at translating assets into profits. We can see this easily when we compare a top notch retailer such as Best Buy with a firm like Circuit City, which was struggling  in the late 1990s and early 2000s. Since 1998, Circuit City’s returns on assets have been around 4 percent to 5 percent, whereas Best Buy’s improved from 5 percent to almost 10 percent (figures 1 and 2)

 

TABLE  1 – Circuit City Profitability
1998 1999 2000 2001 2002
Net Margin(%) 1.4 1.6 1.9 1.4 2.0
Asset turnover (average) 2.6 3.0 3.2 3.0 2.5
Return on assets (%) 3.6 4.8 6.1 4.2 5.0

 

TABLE  2 – Best Buy Profitability
1998 1999 2000 2001 2002
Net Margin(%) 1.1 2.2 2.8 2.6 2.9
Asset turnover (average) 4.4 4.4 4.5 3.9 3.2
Return on assets (%) 4.8 9.7 12.6 10.1 9.3

 

Higher profit margins – almost 3 percent for Best Buy and below 2 percent for Circuit City – are part of the picture, but higher asset turnover is a bigger differentiator between the two. In 2002, for example, each dollar that Circuit City had invested in property and inventory (the two biggest assets for most retailers) generated about $2.50 in sales, while the same dollar invested by Best Buy generated $3.20 in sales. Clearly, Best Buy was running a more efficient shop than Circuit City and was much better at transforming its assets into profits.

ROA helps us understand that there are two routes to excellent operational profitability: You can charge high prices for your products (high margins), or you can turn over your assets quickly. Often, you’ll see companies with lower profit margins, such as grocery stores and discount retailers, emphasize high asset turnover as a way to achieve a solid ROA. For any business that can’t charge any premium for its goods, tight inventory management is critical because it keeps the amount of capital tied up in assets, which helps pump up return on assets. On the flip side, companies that can mark up their goods in a big way – a luxury retailer such as Tiffany, for example – can afford to have more capital tied up in their assets because they make up for low asset turnover with high profit margins.

Just using ROA would be fine if all companies were big pile of assets, but many firms are at least partially financed with debt, which gives their returns a leverage component that we need to take into account. Our next measure or return of capital, return on equity, lets us do this.

Return on Equity (ROE)

Return on Equity is a great overall measure of a company’s profitability because it measures the efficiency with which a company uses shareholders’ equity – in other words, it measures how good the company is at earning a decent return on the shareholder’s money. Think of it as measuring profits per dollar of shareholder’s capital.

To calculate ROE, multiply ROA by a firm’s financial leverage ratio:

Financial leverage = Assets/Shareholders’ Equity

Return on Equity = Return on assets * Financial leverage

Because Return on assets = Net Margin * Asset Turnover, ROE in all its glory equals:

ROE = Net Margin * Asset Turnover * Financial leverage

You’ll notice that we’ve introduced a new metric – financial leverage, which is essentially a measure of how much debt a company carries, relative to shareholders’ equity. Unlike net margin and asset turnover – for which higher ratios are almost unequivocally better – financial leverage is something you need to watch carefully. As with any kind of debt, a judicious amount can boost returns returns, but too much can lead to disaster.

Look at the kind of business the firm is in. If it’s fairly steady, a company can probably take on large amounts of debt without too much risk because there’s only a small chance of the business falling of a cliff and the company being caught short when bondholders demand their interest payments. On the flip side, be very wary of a high financial leverage ratio if a company’s business is cyclical and volatile. Because interest payments are fixed, the company has to pay them whether business is good or bad.

Therefore, we have three levers that can boost ROE – net margins, asset turnover, and financial leverage. For example, a firm could have only a so-so margins and modest levels of financial leverage, but it could do a great job with asset turnover (e.g, a well-run discount retailer such as wall-Mart). Companies with high asset turnover are extremely efficient at extracting more dollars of revenue for each dollar they have invested in hard assets. A firm could also excel at convincing customers to pay up for its products – asset turns might be just middling, and the firm  might not have much leverage, but it would have great profit margins (e.g, a luxury goods company such as Coach). Finally, a firm can boost its ROE to respectable territory by taking on good-sized amounts of leverage (e.g, mature firms such as utilities).
Although it’s tough to generalize, let me offer some rough benchmarks for evaluating firms’ ROEs. In general, any nonfinancial firm that can generate consistent ROE above 10 percent without excessive leverage is at least worth investigating. As of mid-2003, only about one-tenth of the nonfinancial firms in Morningstar’s database were able to post an ROE above 10 percent for each of the past five years, so you can see how tough it is to post this kind of performance. And if you can find a company with the potential for consistent ROE over 20 percent, there’s a good chance you’re really on to something.

Two caveats when you’re using ROE to evaluate firms: first, banks always have enormous financial leverage ratios, so don’t be scared off by a leverage ratio that looks high relative to a nonbank. In addition, because bank’s leverage is always so high, you want to raise the bar for financial firms – look for consistent ROEs above 12 percent or so.
The second caveat concerns firms with ROEs that look too good to be true because they’re usually just that. ROEs above 40 percent or so are often meaningless because they’ve probably been distorted by the firm’s financial structure. Firms tha have been recently spun off from parent firms, companies that have bought back many of their shares, and companies that have taken massive charges often have very skewed ROEs because their equity base is depressed. If you see an ROE over 40 percent, check to see if the company has any of these characteristics.

Free Cash Flow

In the previous chapter, i introduced you to cash flow from operations (CFO), which measures how much cash a company generates. As useful as CFO is, it doesn’t take into account the money that a firm has to spend on maintaining and expending its business. To do this, we need to subtract capital expenditures, which is money used to buy fixed assets. The result is free cash flow.

Free Cash Flow (FCF) = cash flow from operations – Capital expenditures

Thinking back to our hot dog stand example, suppose Mike was so successful that he decided to use the cash he’d generated to build a second hot dog stand. The cost of building that stand would be posted to “capital spending” and subtracted from free cash flow.
Why? We need to be able to separate out businesses that are net users of capital – ones that spend more than they take in – from businesses that are net producers of capital because it’s only that excess cash that really belongs to us as shareholders. you may sometimes see free cash flow referred to as “owner earnings,” because that’s exactly what it is: the amount of money the owner of a company could withdraw from the treasury without harming the company’s ongoing business (Note from Julianek: Buffett disagrees on this definition of owner earnings. Although he agrees that it’s owner earnings that counts, he does not define it the same way. See appendix to the 1986 Berkshire Hathaway letter to shareholders).
A firm that generates a great deal of free cash flow can do all sorts of things with the money – save it for future investment opportunities, use it for acquisitions, buy back shares, and so forth. Free cash flow gives financial flexibility because the firm isn’t relying on the capital markets to fund its expansion. firms that have negative free cash flow have to take out loans or sell additional shares to keep things going, and that become a risky proposition if the market becomes unsettled at a critical time for the company.

As with ROE, it’s tough to generalize about how much free cash flow is enough. However, I think it’s reasonable to say that any firm that’s able to convert more than 5 percent of sales to free cash flow – just divide free cash flow by sale to get this percentage – is doing a solid job at generating excess cash.

 

Putting Return on Equity and Free Cash Flow Together

One good way to think about the returns a company is generating is to use the profitability matrix, which looks at a company’s ROE relative to the amount of free cash flow it’s generating. Figure 3 shows free cash flow along one side and ROE on the other side, and this matrix can tell you a great deal about the kind of company you’re analyzing.
Companies such as Microsoft, Pfizer, and First Data all have very high ROEs. People write books about how to manage a business as well as these companies do, and it’s easy to see why – they’re all money machines. Investors pour new money into them, and large amounts of extra money get spit out. Their managements are very, very good at earning a high return on shareholder’s money.
If you follow any of these companies at all, you’ll notice they have another thing in common beside high ROEs – their stocks all had valuations that were high during the bull market of the 1990s. Again, it’s easy to see why: A company that can earn a high return on its shareholders’ money is worth more to those same shareholders.

Looking at the other axis, we see that these companies are also very good at generating free cash flow in 2002. That’s $8 billion Pfizer made after spending whatever it needed to invest in its business. Pfizer could have chosen to pay that $8 billion – which worked out to about $1.31 per share – out to shareholders. In fact, that’s exactly what older, more mature companies often do with their free cash flow. Their business aren’t growing very fast, and they figure that shareholders can earn a better return on the free cash flow than they can.  So they return it to shareholders in the form of dividends. (This is why very slow-growth firms often have such high yield).
Pfizer, on the other hand, thinks that it can figure out a way to invest that $8 billion more profitably than its shareholders. Because the company is in a relatively fast-growing area of the economy – health care – and has a solid track record of turning out profitable new drugs, it may very well be able to do so. However, if Pfizer started to pile up cash on its balance sheet the way Microsoft has over the past several years, we’d probably conclude that the company doesn’t have many profitable avenues for reinvesting its excess profits. Microsoft’s dividend isn’t very large at this writing, at least the company has one, which means that it has recognized that internal reinvestment opportunities are diminishing.
On the bottom half of the matrix, we have companies such as Amazon.com, Comcast, and Lowe’s, which generate low or negative free cash flow. Companies like these aren’t generating much free cash because they’re using all the cash their businesses generate – and then some – to invest in expansion. They’re investing heavily because they hope that those expansion efforts will pay off in the form of fat profits in the future. Amazon, for example, is spending heavily on building a brand and expanding its web site, while JetBlue is spending heavily on new airplanes so that it can expand its service to new cities.
JetBlue and Amazon are like young entrepreneurs. they’ve taken out loans and maxed out their credit cards, and they’re plowing every cent they have into building and expanding their businesses. Although they’re not earning much in the way of profits right now, folks are investing in their businesses because they expect these companies to be very profitable sometime in the future, which is when investors will be rewarded. Pfizer, on the other hand, is more like a successful, middle-aged businessman. He’s already proven he can earn a good return on shareholder’s money, so folks line up outside his door for the privilege of investing in his ventures.
You’d be taking a lot less risk investing with the older businessman than you would with the young entrepreneur – though that entrepreneur might pay you back many, many times over. Just remember that for every Jeff Bezos or Steve Jobs, there are literally hundreds of entrepreneurs who never paid their investors a dime.
There’s nothing wrong with investing in the entrepreneurs of the world, as long as you know what you’re getting into. A profitability matrix can help you separate your long shots from your core holdings.
Think of the profitability matrix like this: That upper right-hand corner, where Pfizer sits, is the sweet spot – excess cash and the ability to earn a high return on it. Companies in this square tend to be the cream of the crop and have a low level of business risk (they might be very risky stocks, though, if they’re trading at high valuations).

Moving down to the bottom right, where Lowe’s is, you see companies that are reinvesting all of their cash in expansion but are still able to generate a high return on shareholders’ money. If these firms still have profitable reinvestment opportunities, they should be spending all that cash they generate on expansion. for example, Starbucks and Home depot posted high ROEs and negative free cash flow all through the 1990s because they were plowing every cent they earned into building more stores.
In the bottom left are young companies growing like weeds, but which haven’t yet proven that they can earn a decent ROE – they’re spending tons of money, but they’re not yet making it pay off very well. This is where the most speculative companies hang out. These companies are generally long shots because it’s still unclear whether all of that heavy investment will ever generate an attractive return.

 

Return on Invested Capital (ROIC)

Return on invested capital is a sophisticated way of analyzing return on capital that adjust for some peculiarities of ROA and ROE. It’s worth knowing how to interpret it because it’s overall a better measure of profitability than ROA and ROE. Essentially, ROIC improves on ROA and ROE because it puts debt and equity financing on an equal footing: it removes the debt-related distortion that can make highly leveraged companies look very profitable when using ROE. It also uses a different definition of profits than ROE and ROA, both of which use net income. ROIC uses operating profits after taxes, but before interest expenses. Again, the goal is to remove any effects caused by a company’s financing decisions – does it use debt or equity? – so that we can focus as closely as possible on the profitability of the core business. what does all this mean to you if you hear someone talking about ROIC? Simply that you should interpret ROIC just as you would  with ROA and ROE – a higher return on invested capital is preferable to a lower one.

Calculation of ROIC

The true operating performance of a firm is best measured by return on invested capital (ROIC), which measures the return on all capital invested in the firm regardless of the source of the capital. The formula for ROIC is deceptively simple:

ROIC = Net operating profit after taxes (NOPAT)/ invested capital

The numerator of this equation is easy: profits after taxes, but before interest costs. The denominator is a bit trickier and although there are many different ways to calculate it, you’ll do just fine if you use this version:

Invested Capital = Total assets – Non Interest bearings current liabilities – Excess cash

Non Interest bearings current liabilities are usually accounts payable and other current liabilities.
Excess cash is cash not needed to run the day-to-day business needs.
You may also want to subtract goodwill if it’s a large percentage of assets.

Let’s run through an example: At the end of fiscal 2002, Wal-Mart’s total assets were worth $94.7 billion. Subtract accounts payable, accrued liabilities, and accrued income taxes, and $67.7 billion remains, which is Wal-Mart invested capital. Looking at the firm’s income statement, we see that operating profit was $13.6 billion. If we multiply this by the firm’s 36 percent tax rate, we get a rough idea of what taxes wold have been without any interest income or interest expense (remember, interest is tax deductible for corporations), and we find that NOPAT equals $13.6 – ($13.6*0.36) = $8.7 billion.

Next, divide NOPAT by invested capital, or $8.7 billion by $67.7 billion, and ROIC is 12.9 percent – pretty respectable for a firm as large and mature as Wal-Mart.

Financial Health

Once we’ve figured out how fast and why a company has grown and how profitable it is, we need to look at its financial health. Even the most beautiful home needs a solid foundation, after all.

The bottom line about financial health is that when a company increases its debt, it increases its fixed costs as a percentage of total costs. In years when business is good, a company with high fixed costs can be extremely profitable because once those costs are covered, any additional sales the company makes fall straight to the bottom line. When business is bad, the fixed costs of debt push earnings even lower.

Look at what debt does to the earnings volatility of the creatively named Acme Corporation (see figure 4). With more debt, Acme’s earnings fluctuate a lot: They’re up more in good times and down more in bad times.

A common measure of leverage is simply the financial leverage ratio that we used in calculating ROE, equal to assets divided by equity. Think of the financial leverage like a mortgage – a homebuyer who puts $20,000 down on a $100,000 house has a financial leverage ratio of 5. For every dollar in equity, the buyer has $5 in assets.
The same holds true for companies. In 2002, home improvement retailer Lowe’s had a financial leverage of 2.1, meaning that for every dollar in equity, the firm had $2.10 in total assets (it borrowed the other $1.10). A financial leverage ratio of 2.1 is fairly conservative, even for fast-growing retailer. it’s when we see ratios of 4, 5 or more than companies start to get really risky.

In addition to financial leverage, make sure to examine a few other key metrics when assessing a company’s financial health.

Debt to Equity

This is just what it sounds like – long term debt divided by shareholders’ equity. It’s a little like the financial leverage ratio, except that it’s more narrowly focuses on how much long-term debt the firm has per dollar of equity.

Times Interest Earned

This one requires a little more work to calculate, but it’s worth it. Look up pretax earnings, and add back interest expense – this gives earnings before interest and taxes (EBIT). Divide EBIT by interest expense, and you’ll know how many times (hence the name) the company could have paid the interest expense on its debt. The more times that the company could have paid its interest expense, the less likely that it will run into difficulty if earnings should fall unexpectedly.
For home improvement retailer Lowe’s, for example, we add $182 million in interest expenses to $2.36 billion in pretax earnings to get $2.54 billion in EBIT, and we divide $2.54 billion by the $182 million in interest expense to get times interest earned of 14. In other words, Lowe’s earned enough money in 2003 to cover its interest obligation 14 times over, which is a pretty safe margin.

 

TABLE 5- Lowe’s companies : Partial Income Statement
In millions, Fiscal year ending 2003
Net Sales $26,491
Cost of Sales 18,465
Gross Margin 8,026
Expenses :
SG&A 4,730
Store Opening Costs 129
Depreciation 626
Interest 182
Total Expenses 5,667
Pre-Tax Earnings 2,359
Income tax provision 888
Net Earnings $1,471

It’s tough to say precisely how low this metric can go before you should be concerned – but higher is definitely  better. You want to see higher times interest earned for a company with a more volatile business than a firm in a more stable industry.  Be sure to look at the trend in times interest earned over time, as well. Calculate the ratio for the past five years, and you’ll be able to see whether the company is becoming riskier – times interest earned is falling – or whether its financial health is improving.

 

Current and Quick Ratio

The current ratio (current assets divided by current liabilities) simply tells you how much liquidity a firm has – in other words, how much cash it could raise if it absolutely had to pay off its liabilities all at once. A low ratio means the company may not be able to source enough cash to meet near-term liabilities, which would force it to seek outside financing or to divert operating income to pay off those liabilities). As a very general rule, a current ratio of 1.5 or more means the firm should be able to meet operating needs without much trouble.
Unfortunately, some current assets – such as inventories- may be worth less than their value on the balance sheet (Imagine trying to sell old PCs or last year’s fashion to generate cash – you’d be unlikely to receive anything close to what you paid for them). So there’s an even more conservative test of a company’s liquidity, the quick ratio, which is simply current assets less inventories divided by current liabilities. This ratio is especially useful for manufacturing firms and for retailers because both of these types of firms tend to have a lot of their cash tied up in inventories. In general, a quick ratio higher than 1.0 puts a company in fine shape, but always look at other firms in the same industry to be sure.

Takeaways:

    • Returns on Assets measure the amounts of profits that a company is able to generate per dollar of assets. Companies with high ROAs are better at translating assets into profits.
    • ROE is a good measure of profitability because it measures how the company is at earning a return on shareholders’ money. But because companies can boost their ROEs by taking on more debt, don’t take it as gospel. For a nonfinancial company, look for an ROE of at least 10 percent, without excessive leverage.
    • Free cash flow gives financial flexibility because the firm isn’t relying on the capital markets to fund its expansion. Firms with negative free cash flow have to take out loans  or sell additional shares to keep things going, and that can become a risky proposition if the market becomes unsettled at a critical time for the company
    • Be wary of companies with too much financial leverage. Because debt is a fixed cost, it magnifies earnings volatility and leads to more risk.
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