Thursday, February 23, 2012

Cash and Profits

If you’re a follower of my blog, you would know that I value an investment based on the future cash flows that the investment is expected to generate for shareholders (I wrote extensively about cash flows in this article here). That doesn’t mean I think profits don’t matter. In fact, I think profits are very important and will determine whether or not the company will turn out to be a good investment.

Side note: The return on equity is the best measure of profitability as it measures the returns earned on the money belonging to shareholders, the returns earned on your money. The return on equity must not have been achieved by means of using excessive debt or taking excessive risks.

We make an investment because we think that the asset we invested in will generate more cash (after adjusting for inflation and taxes) than our initial investment. But to be able to generate cash, the company needs to hire people, buy materials, and make capital expenditures. And if the company achieves only a low return on equity and is very asset-intensive, then the company will be in a position where it has to plow back huge amounts of cash, cash that could be paid out as dividends and invested by the shareholders at higher returns, to maintain its future cash flows. The company would be throwing good money after bad.

On the other hand, if the company is asset-light and earns good returns on equity, then the company would need to reinvest less money to maintain future cash flows. This would leave the company with more cash to do share buybacks, pay out dividends, and/or reinvest in the business to increase future cash flows.

Now that we have established that both profits and cash flows are important, the next step would be to decide on a level of profitability that we should require from our investments. I personally look for companies that generate long-term returns on equity of 15% and above (higher if the company operates in a high inflation environment, after all it’s real profitability that we’re after not nominal, inflated profitability). I will generally reject any potential stock investments that don’t meet this criterion.

If you have any questions or have anything that you would like to add please feel free to comment or send me a private message. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.