Thursday, October 21, 2010

Earnings quality: Identifying good earners (return on equity)

It’s a fact that the quality of earnings can differ from company to company. Two companies reporting the exact same profits can make for very different investments in terms of the long-term value they can create for shareholders. The reason that some companies have better quality earnings than others:  their return on equity.

Companies that earn high returns on equity can reinvest their earnings at attractive rates of return, while companies that earn low returns on equity can only reinvest their earnings at unattractive rates of return. Over time, the difference is huge.

Let’s assume that there are two companies, company A and company B. Both of these companies reinvest $1000 in their operations at the end of each year for 10 years; company A has a return on equity of 15% and company B has a return on equity of 5%. The future value of company A’s reinvested earnings is about    $20,300, while the future value of company B’s reinvested earnings is only about $12,580. That’s about 38% more money for shareholders of company A. You might have already guessed that I calculated the future value of the retained earnings the same way you would calculate the future value of an annuity. (Here’s a future value of an annuity calculator you can use).

Companies that earn higher returns on equity will usually be assigned a higher valuation by investors, as the investors recognize that these are good companies that can generate great, sustainable returns for shareholders. There are times when the higher valuation is warranted (sometimes the market even undervalues some of these companies), and as we all know, it’s always better to invest in a good company at a fair price than invest in a lousy company at a cheap price.

The only thing that can be done by the management of a company that earns a low return on its equity is to pay out as much of the company’s profits as it can in the form of dividends, which investors can put to work at better rates of return. The problem really comes when some of these companies have to make large, regular capital expenditures just to maintain current profitability, reducing their ability to pay out dividends.

Even if these companies can afford to pay out most of their earnings as dividends, investors will still use the dividends they get to invest in the better quality companies. Investors have to pay taxes on their dividends, and this will cause investors to still be worse off than if they were to directly invest in the better quality companies from the start and let those companies reinvest in their operations or buy back stock (side-stepping dividend income taxes). Both of these activities should, of course, result in capital gains for the investors.  

Sometimes the market can drastically undervalue some companies, and investors can make good profits buying the shares of these companies, even if these companies have a low return on equity. Investors just have to make sure that they take extreme caution when deciding on the investment appeal of these companies, especially the ones with a history of having a low dividend payout ratio, and the ones that have to make large, regular capital expenditures. While a long-term approach is required when investing in companies that can  earn only below market returns on their equity, these are not companies you should hold forever, but are companies that should be sold once they approach your estimates of intrinsic value.     

If you have any questions, or if you have anything that you would like to share, please feel free to comment. Thank you for reading and may you always sustain good returns on your portfolio. Take care.