Finding stocks with great management (Part I)
In my recent post on using free cash flows to see through GAAP income numbers, I touched on the difference between enterprise value and equity investing. When using enterprise value, you value a business based purely on its ability to generate free cash flow. Enterprise value investing presupposes that if you were to buy the entire business, you’d be able to make capital allocation decisions which allow you to extract value from free cash flow. The typical stock market investor rarely has this type of control over a business.
As a shareholder, always remember that you have a right to your portion of the Company’s profits. But, as it wouldn’t make sense from a planning perspective to distribute profits each quarter based on the whims of a disparate shareholder group, management and the board of directors is given the fiduciary duty to determine what to distribute and what to keep as retained earnings. As a non-control investor, you must decide whether or not these decisions can create value for you as a shareholder.
Using the example of a savings account, if you chose to put $100 in a savings account, you’d likely demand a return of 3% or more. In the same sense, if management of a Company you’re invested in came to you with the proposition, “We can give you every dollar the Company earns this year or you can let us reinvest the profits and build a bigger more valuable company next year,” you’d have some demands as far as how much more value they can deliver to you. Not to mention the fact that by allowing them to control the Company’s earnings, you’re also giving up the opportunity of taking the money and putting it into a risk free savings account. So, how can you tell if management is effectively reinvesting your dollars or how much to expect from their efforts going forward??
Return on Equity
The simplest measure of investment efficacy is:
net income / shareholders’ equity
Basically, for the capital that shareholders invest in this business, how much profit is returned? As retained earnings are held on the balance sheet within shareholders’ equity, this simple ratio gives you proxy for how well the Company has generated return on equity investments so far and the incremental net income growth you should expect on each dollar of earnings you allow them to retain.
Return on Invested Capital
ROE is inherently weakened by the fact that businesses can secure investment capital in more ways than just equity. If the Company borrows a lot of money to fund growth, it can juice its return on equity numbers pretty significantly. A better metric might look like:
net income / (shareholders’ equity + longterm debt)
This number, for any business that has long term debt will be lower than, return on equity. But, it is likely a more accurate picture of the return you can expect for each marginal dollar that management spends to grow the business.
Is higher ROE or ROIC always better?
Remember that ROE and ROIC are inherently backward looking formulas. They can only be used for you to evaluate how management has invested capital historically. The law of diminishing marginal returns implies that return on each new dollar invested will fall in the future.
The best management teams do one of two things.
- They maintain or grow on their historical ROIC rates.
- Or, they recognize the diminishing value of their efforts and move quickly to distribute profits to shareholders as opposed to waste it in ill conceived attempts to grow the business.
Large acquisitions, the start up of new non-core businesses, ever increasing headcounts, and continual purchase of new equipment are all examples of red flags. Remember that sometimes you won’t see net income growth immediately but, if return on invested capital remains at depressed levels or continues to decline over a several year period, it may be time to get out of Dodge.
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