January 2019 Data Update 6: Profitability and Value Creation!

In my last post, I looked at hurdle rates for companies, across industries and across regions, and argued that these hurdle rates represent benchmarks that companies have to beat, to create value. That said, many companies measure success using lower thresholds, with some arguing that making money (having positive profits) is good enough and others positing that being more profitable than competitors in the same business makes you a good company. In this post, I will look at all three measures of success, starting with the minimal (making money), moving on to relative judgments (and how best to compare profitability across companies of different scales) and ending with the most rigorous one of whether the profits are sufficient to create value.

Measuring Financial Success

You may start a business with the intent of meeting a customer need or a societal shortfall but your financial success will ultimately determine your longevity. Put bluntly, a socially responsible company with an incredible product may reap good press and have case studies written about it, but if it cannot establish a pathway to profitability, it will not survive. But how do you measure financial success? In this portion of the post, I will start with the simplest measure of financial viability, which is whether the company is making money, usually from an accounting perspective, then move the goal posts to see if the company is more or less profitable than its competitors, and end with the toughest test, which is whether it is generating enough profits on the capital invested in it, to be a value creator.

Profit Measures

Before I present multiple measures of profitability, it is useful to step back and think about how profits should be measured. I will use the financial balance sheet construct that I used in my last post to explain how you can choose the measure of profitability that is right for your analysis:

Just as hurdle rates can vary, depending on whether you take the perspective of equity investors (cost of equity) or the entire business (cost of capital), the profit measures that you use will also be different, depending on perspective. If looked at through the eyes of equity investors, profits should be measured after all other claim holders (like debt) and have been paid their dues (interest expenses), whereas using the perspective of the entire firm, profits should be estimated prior to debt payments. In the table below, I have highlighted the various measures of profits and cash flows, depending on claim holder perspective:

The key, no matter which claim holder perspective you adopt, is to stay internally consistent. Thus, you can discount cash flows to equity (firm) at the cost of equity (capital) or compare the return on equity (capital) to the cost of equity (capital), but you cannot mix and match.

The Minimal Test: Making money?

The lowest threshold for success in business is to generate positive profits, perhaps the reason why accountants create measures like breakeven, to determine when that will happen. In my post on measuring risk, I looked at the percentages of firms that meet this threshold on net income (for equity claim holders), an operating income (for all claim holders) and EBITDA (a very rough measure of operating cash flow for all claim holders). Using that statistic for the income over the last twelve month, a significant percentage of publicly traded firms are profitable:

Data, by country

The push back, even on this simplistic measure, is that just as one swallow does not a summer make, one year of profitability is not a measure of continuing profitability. Thus, you could expand this measure to not just look at average income over a longer period (say 5 to 10 years) and even add criteria to measure sustained profitability (number of consecutive profitable years). No matter which approach you use, you still will have two problems. The first is that because this measure is either on (profitable) or off (money losing), it cannot be used to rank or grade firms, once they have become profitable. The other is that making money is only the first step towards establishing viability, since the capital invested in the firm could have been invested elsewhere and made more money. It is absurd to argue that a company with $10 billion in capital invested in it is successful if it generates $100 in profits, since that capital invested even in treasury bills could have generated vastly more money.

The Relative Test: Scaled Profitability

Once a company starts making money, it is obvious that higher profits are better than  lower ones, but unless these profits are scaled to the size of the firm, comparing dollar profits will bias you towards larger firms. The simplest scaling measure is revenues, a data item available for all but financial service firms, and one that is least likely to be affected by accounting choices, and profits scaled to revenues yields profit margins. In a data update post from a year ago, I provided a picture of different margin measures and why they might provide different information about business profitability:

As I noted in my section on claimholders above, you would use net margins to measure profitability to equity investors and operating margins (before or after taxes) to measure profitability to the entire firm. Gross and EBITDA margins are intermediate stops that can be used to assess other aspects of profitability, with gross margins measuring profitability after production costs (but before selling and G&A costs) and EBITDA margins providing a crude measure of operating cash flows.

In the graph below, I look at the distribution of pre-tax operating margins and net margins globally, and provide regional medians for the margin measures:

The regional comparisons of margins are difficult to analyze because they reflect the fact that different industries dominate different regions, and margins vary across industries. You can get the different margin measures broken down by industry, in January 2019, for US firms by clicking here. You can download the regional averages using the links at the end of this post.

The Value Test: Beating the Hurdle Rate

As a business, making money is easier than creating value, since to create value, you have to not just make money, but more money than you could have if you had invested your capital elsewhere. This innocuous statement lies at the heart of value, and it is in fleshing out the details that we run into practical problems on the three components that go into it:

1. Profits: The profit measures we have for companies reflect their past, not the future, and even the past measures vary over time, and for different proxies for profitability. You could look at net income in the most recent twelve months or average net income over the last ten years, and you  could do the same with operating income. Since value is driven by expectations of future profits, it remains an open question whether any of these past measures are good predictors.
2. Invested Capital: You would think that a company would keep a running tab of all the money that is invested in its projects/assets, and in a sense, that is what the book value is supposed to do. However, since this capital gets invested over time, the question of how to adjust capital invested for inflation has remained a thorny one. If you add to that the reality that the invested capital will change as companies take restructuring charges or buy back stock, and that not all capital expenses finds their way on to the balance sheet, the book value of capital may no longer be a good measure of capital invested in existing investments.
3. Opportunity Cost: Since I spent my last post entirely on this question, I will not belabor the estimation challenges that you face in estimating a hurdle rate for a company that is reflective of the risk of its investments.

In a perfect world, you would scale your expected cashflows in future years, adjusted for time value of money, to the correct amount of capital invested in the business and compare it to a hurdle rate that reflects both your claim holder choice (equity or the business) but also the risk of the business. In fact, that is exactly what you are trying to do in a good intrinsic or DCF valuation. 

Since it is impossible to do this for 42000 plus companies, on a company-by-company basis, I used blunt instrument measures of each component, measuring profits with last year's operating income after taxes, using book value of capital (book value of debt + book value of equity - cash) as invested capital:

Similarly, to estimate cost of capital, I used short cuts I would not use, if I were called up to analyze a single company: 

Comparing the return on capital to the cost of capital allows me to estimate excess returns for each of my firms, as the difference between the return on invested capital and the cost of capital. The distribution of this excess return measure globally is in the graph below:

I am aware of the limitations of this comparison. First, I am using the trailing twelve month operating income as profits, and it is possible that some of the firms that measure up well and badly just had a really good (bad) year. It is also biased against young and growing firms, where future income will be much higher than the trailing 12-month value. Second, operating income is an accounting measure, and are affected not just by accounting choices, but are also affected by the accounting mis-categorization of lease and R&D expenses. Third, using book value of capital as a proxy for invested capital can be undercut by not only whether accounting capitalizes expenses correctly but also by well motivated attempts by accountants to write off past mistakes (which create charges that lower invested capital and make return on capital look better than it should). In fact, the litany of corrections that have to be made to return on capital to make it usable and listed in this long and very boring paper of mine. Notwithstanding these critiques, the numbers in this graph tell a depressing story, and one that investors should keep in mind, before they fall for the siren song of growth and still more growth that so many corporate management teams sing. Globally, approximately 60% of all firms globally earn less than their cost of capital, about 12% earn roughly their cost of capital and only 28% earn more than their cost of capital. There is no region of the world that is immune from this problem, with value destroyers outnumbering value creators in every region.

Implications

From a corporate finance perspective, there are lessons to be learned from the cross section of excess returns, and here are two immediate ones:

1. Growth is a mixed blessing: In 60% of companies, it looks like it destroys value, does not add to it. While that proportion may be inflated by the presence of bad years or companies that are early in the life cycle, I am sure that the proportion of companies where value is being destroyed, when new investments are made, is higher than those where value is created.
2. Value destruction is more the rule than the exception: There are lots of bad companies, if bad is defined as not making your hurdle rate. In some companies, it can be attributed to bad managed that is entrenched and set in its ways. In others, it is because the businesses these companies are in have become bad business, where no matter what management tries, it will be impossible to eke out excess returns.

You can see the variations in excess returns across industries, for US companies, by clicking on this link, but there are clearly lots of bad businesses to be in. The same data is available for other regions in the datasets that are linked at the end of this post.

If there is a consolation prize for investors in this graph, it is that the returns you make on your investment in a company are driven by a different dynamic. If stocks are value driven, the stock price for a company will reflect its investment choices, and companies that invest their money badly will be priced lower than companies that invest their money well. The returns you will make on these companies, though, will depend upon whether the excess returns that they deliver in the future are greater or lower than expectations. Thus, a company that earns a return on capital of 5%, much lower than its cost of capital of 10%, which is priced to continue earning the same return will see if its stock price increase, if it can improve its return on capital to 7%, still lower than the cost of capital, but higher than expected. By the same token, a company that earns a return on capital of 25%, well above its cost of capital of 10%, and priced on the assumption that it can continue on its value generating path, will see its stock price drop, if the returns it generates on capital drop to 20%, well above the cost of capital, but still below expectations. That may explain a graph like the following, where researchers found that investing in bad (unexcellent) companies generated far better returns than investing in good (excellent) companies:

Original Paper: Excellence Revisited, by Michelle Klayman

The paper is dated, but its results are not, and they have been reproduced using other categorizations for good and bad firms. Thus, investing in the most admired firms generates worse returns for investors than investing in the least admired and investing in popular (with investors) firms under performs investing in unpopular ones. While these results may seem perverse, at first sight, that bad (good) companies can be good (bad) investments, it makes sense, once you factor in the expectations game. 

Finally, on the corporate governance front, I feel that we have lost our way. Corporate governance laws and measures have focused on check boxes on director independence and corporate rules, rather than furthering the end game of better managed companies. From my perspective, corporate governance should give stockholders a chance to change the way companies are run, and if corporate governance works well, you should see more management turnover at companies that don't earn what they need to on capital. The fact that six in ten companies across the globe earned well below their cost of capital in 2018, added to the reality that many of these companies have not only been under performing for years, but are still run by the same management, makes me wonder whether the push towards better corporate governance is more talk than action.

YouTube Video


Data Links

1. Profit Margins: US, Global, Emerging Markets, Europe, Japan, India, China, Aus & Canada
2. Excess Returns to Equity and Capital: US, Global, Emerging Markets, Europe, Japan, India, China, Aus & Canada

Papers

1. Return on Capital, Return on Invested Capital and Return on Equity: Measurement and Implications (Warning: It is long and boring!) 

Related Posts

1. Explaining a Paradox: Why good companies can be bad investments and vice versa

January 2019 Data Updates

1. Data Update 1: A Reminder that equities are risky, in case you forgot!
2. Data Update 2: The Message from Bond Markets
3. Data Update 3: Playing the Numbers Game
4. Data Update 4: The Many Faces of Risk
5. Data Update 5: Of Hurdle Rates and Funding Costs!
6. Data Update 6: Profitability and Value Creation!
7. Data Update 7: Debt, neither poison nor nectar!
8. Data Update 8: Dividends and Buybacks - Fact and Fiction!
9. Data Update 9: Playing the Pricing Game!

Read More

January 2018 Data Update 7: Growth and Value

I have spent the last few posts trying to estimate what firms need to generate as returns on investments, culminating in the cost of capital estimates in the last post. In this post, I will look at the other and perhaps more consequential part of the equation, by looking at what companies generate as profits and returns. Specifically, as I have in prior years, I will examine whether the returns generated by firms are higher than, roughly equal to or lower than their costs of capital, and in the process, answer one on the fundamental questions in investing. Does growth add or destroy value?

Profitability

The simplest and most direct measures of profitability remain profit margins, with profits scaled to revenues for most firms. That said, there are variants of profit margins that can be computed depending on the earnings measure used:

At the risk of stating the obvious, the margins you compute will look larger and healthier, for any firm, as you climb up the income statement. As to which of these various measures of profitability you use, the answer depends on the following:

• What are you trying to value? If your focus is on just equity investors and you are either doing a DCF built around equity cash flows (Dividends or Free Cash Flow to Equity) or using an equity multiple (PE, Price to Sales or Price to Book), your focus will be on profits to equity investors, i.e,, net margin. In a DCF valuation built around pre-debt cash flows (FCFF) or if you are working with enterprise value multiples EV/FCFF, EV/EBITDA or EV/Sales), your focus will shift to income prior to interest expenses, leaving you with a choice between operating income and EBITDA multiples.
• What are you trying to measure? If you are attempting to compare production efficiency across firms, the gross margin is your best measure, because it looks at the profits you will generate, per unit sold, after you have covered the direct cost of production. If you are attempting to compare operating efficiency, at the business level, the operating margin is a better device. That is because for companies that have to spend substantially on sales, marketing and other structural operating costs, the operating income can be substantially lower than the gross income. The net margin is almost never a good measure of operating efficiency, simply because it is affected significantly by how you finance your business, with more debt leading to lower net profits and net margins.
• Where are you in the life cycle?  I use the corporate life cycle as a vehicle for talking about transitions in companies, from the right type of CEO for a firm to which pricing metric to use. The profit margins you focus on, to measure success and viability, will also shift as a company moves through the life cycle:
  
• What are you selling? For better or worse, business people who are seeking your capital try to frame the profitability of their businesses by pointing to the profit margins. Since margins look better as you move up the income statement, business promoters are more inclined to use gross and EBITDA margins to make their cases than after-tax operating or net margins. While that is perfectly understandable, and even justifiable, for a young company that is scaling up (see life cycle bullet above), it is a sign of desperation when companies continue to point to gross margins as their measures of profitability as they age. 

With that long set up, let's look at the profitability of publicly traded companies around the world on three dimensions: across time, across companies and across sectors. At the start of 2018, as I have in prior years, I computed gross, EBITDA, operating (pre and post-tax) and net profit margins for every publicly traded company in my sample. The distribution of net and pre-tax operating margins, across all companies globally, can be seen below:

Not only are there no surprises here, but it is not easy to use this cross sectional distribution to pass judgment on your company's relative profitability for a simple reason. The median operating margin across all companies is 4.16% bu it varies widely across different businesses, partly because of differences in operating structure and scaleablity, partly because of competition and partly because of differences in the use of financial leverage (at least for net margins. The picture below reports gross, operating and net margins, by sector, for global companies at the start of 2018:

Download spreadsheet with all margin data

I find profit margins to be extraordinarily useful, when valuing companies, both for comparison purposes and as the basis for my forecasts for the future. If you look at almost every valuation that I have done on this blog or in my classes, a key input that drives my forecast of earnings in future years is a target margin (either operating or net). It is also the metric that lends itself well to converting stories to numbers, another obsession of mine. Thus, if your story is that your company will benefit from economies of scale, I reflect that story by letting its operating margins improve over time, and if your narrative is that of a company with a valuable brand name, I endow it with much higher operating margins than other companies in the sector, but there is one limitation of profit margins. If your focus is on answering the question of whether your company is a "good" or a "bad" company, looking at margins may not help very much. There are "low-margin" good companies, like Walmart, that make up for low margins with high sales turnover and "high-margin" bad companies, that invest a great deal and sell very little, with many high-end retailers and manufacturers falling into this grouping. It is to remedy these problems that I will turn to measuring profitability with accounting returns, in the next section.

The Excess Return Picture - Global

Unlike profit margins, where profits are scaled to revenues, accounting returns scale profits to invested capital. Here, while there are multiple measures that people use, there are only two consistent measures. The first is to scale net income to the equity invested in a  company, measured usually by book value of equity, to estimate return on equity. The other is divide operating income, either pre-tax or post-tax, by the capital invested in a company, to estimate return on invested capital. While you will see both in user, there are two key factors that should color which one you focus on and how much to trust that number.

• Claimholder Consistency: As to which measure of accounting return you should use to measure investment quality, the answer is a familiar one. It depends on whether you are measuring returns from an equity or from a business perspective:
  
• Accounting Numbers: The first is that no matter how carefully you work with the numbers, the return on equity and return  on capital are quintessentially accounting numbers, with both the numerator (earnings) and denominator (book value of equity or invested capital) being accounting numbers.
  
  Consequently, any accounting actions, no matter how well intentioned, will affect your return on invested capital. For instance, an accounting write off of a past investment will reduce book value of both equity and invested capital and increase your return on capital. If you want to delve into the details, my condolences, but you can read this really long, really boring paper that I have on measurement issues with the return on equity and capital.

Since accounting returns can vary, depending upon your estimation choices, it is important that I be transparent in the choices I made to compute the returns for the 43,884 firms in my sample:

Once I have the measures of these returns, I can compare them with the costs of equity and invested capital that I have estimated already for these companies to estimate excess returns (ROIC - Cost of Capital) for each firm. The distribution across all firms is reported below:

With all the caveats about accounting returns in place, this comparison is one of the most important ones in valuation and finance, for a simple reason. If the accounting return is a good measure of what you actually earn on your invested capital, and the cost of capital is the rate of return that you need to make on that invested capital to break even, a "good" company should generate positive excess returns, a "neutral" company should earn roughly its cost of capital and a " bad" company should have trouble earning its cost of capital. Using 2017 numbers, 22,062 companies, representing 61.7% of the 35,738 companies that I was able to estimate returns on capital for, would have fallen into the "bad" company category. It is true that my accounting returns are based upon one year's earnings, and that even good companies have bad years, and using a normalized return on capital (where I use the average return on capital earned over 10 years) does brighten the picture a bit:

Note, that this is a comparison biased significantly towards finding good news, since by using a ten-average for the return on invested capital, I am reducing my sample to 14,502 survivor firms, more likely to be winners than losers. Even in this more optimistic picture, 2524 firms (30.2%) earn less than the cost of capital and have done so for a decade. Put simply, there are lots of companies that are bad companies, either because they are in bad businesses or because they are badly managed, and many of these companies have been bad for a long time. If there is a better reason for pushing for stronger corporate governance and more activist investors, I cannot think of it.

Exploring the Differences in Returns

As you digest the bad news in the cross section, if you are a manager or investor, you are probably already looking for reasons why your company or business is the exception. After all, excess returns can vary across parts of the world, different business or company size. It is in pursuit of that variation that I decided to look at excess returns, broken down on these dimensions.

1. Geographical

Are companies in some parts of the world likely to earn better returns on investments than others? Generally, you would expect companies in markets that are more protected from competition (either domestic or global) to do better than companies in markets where competition is fierce. In the table below, I look at excess returns, broken down by region:

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Sub Group	Number of firms	Return on Capital	Cost of Capital	ROIC - Cost of Capital	% with +ve Excess Returns
Africa and Middle East	2,277	5.88%	8.76%	-2.88%	34.55%
Australia & NZ	1,777	4.71%	7.97%	-3.26%	31.88%
Canada	2,850	5.69%	8.39%	-2.70%	19.07%
China	5,552	5.11%	8.13%	-3.02%	45.57%
EU & Environs	5,399	5.50%	7.74%	-2.24%	43.80%
Eastern Europe & Russia	558	9.63%	9.03%	0.60%	41.67%
India	3,511	10.33%	8.96%	1.38%	40.24%
Japan	3,755	5.63%	7.74%	-2.11%	45.06%
Latin America & Caribbean	880	6.68%	8.80%	-2.12%	43.63%
Small Asia (wo China, India & Japan)	8,630	7.21%	9.33%	-2.12%	32.60%
UK	1,412	5.53%	7.78%	-2.24%	47.62%
United States	7,247	6.75%	7.50%	-0.75%	36.41%

If you are holding out hope that your region is the exception to the rule, this table probably dispels that hope. One of the two regions of the world where companies earn more than their cost of capital is India, which the cynics will attribute to accounting game playing, but may also reflect the protection from competition that some sectors in India, especially retail and financial services, have been offered from foreign competition. The sobering note, though, is that as India opens these sheltered businesses up for competition, these excess returns will come under pressure and perhaps dissipate. It is interesting that the other part of the only other region of the world where companies earn more than their cost of capital is Eastern Europe and Russia, where competitive barriers to entry remain high. China, the other big market in terms of population, does not seem to offer the same positive excess returns, and that should be a cautionary note for those who tell the China story to justify sky high valuations for companies growing there. With US companies, the returns on capital reflect the effective tax rate paid last year (about 26%) and, if you hold all else constant, you should see an increase in the return on capital in 2018, a point I made in my post on taxes.

2. Business or Sector

It stands to reason that it is easier to earn excess returns in some businesses than others, mostly because there are barriers to entry. Thus, you should expect businesses built on patents and exclusive licenses to offer more positive excess returns than businesses where there are no such barriers. To examine differences across sectors, I looked at excess returns, by sector, for US companies, in January 2018, and classified them into good businesses (earning more than the cost of capital) and bad businesses (earning less than the cost of capital). While the entire sector data is available for both US and Global companies, the list below highlights the non-financial service sectors that earn less than the cost of capital:

Industry Name	ROC	Cost of Capital	(ROC - WACC)
Electronics (Consumer & Office)	-5.54%	7.67%	-13.21%
Oil/Gas (Production and Exploration)	0.09%	7.76%	-7.67%
Oil/Gas (Integrated)	2.15%	8.45%	-6.30%
Green & Renewable Energy	1.94%	5.77%	-3.83%
Shipbuilding & Marine	4.88%	8.26%	-3.38%
Real Estate (Development)	2.27%	5.21%	-2.93%
Insurance (General)	2.82%	5.38%	-2.55%
R.E.I.T.	3.08%	4.43%	-1.35%
Real Estate (General/Diversified)	4.32%	5.58%	-1.26%
Auto & Truck	3.97%	5.06%	-1.09%
Oilfield Svcs/Equip.	6.42%	7.44%	-1.02%
Telecom (Wireless)	5.43%	5.72%	-0.29%

Some of the sectors that fall into the bad business column did not surprise me, since they have been long standing members of this club. The automobile and shipbuilding businesses have been bad businesses,almost every year that I have looked at it for the last decade. Some of the sectors on this list will attribute their place on the list to macro concerns, with oil companies pointing to low oil prices. There are still others, though, that are recent entrants to this club, and  represent the dark side of disruption, where their businesses have been altered by either technology or new entrants. The electronics business is one example, where margins have collapsed and returns have followed The telecommunications business, was for long a solid business, where big infrastructure investments were funded with debt, but the companies (whether they be phone or cable) were able to use their quasi or regulated monopoly status to pass those costs on to their customers, but it has now slipped into the bad business column, as technology has undercut its monopoly powers. With financial service firms, where the excess returns are better measured by looking at the difference between ROE and cost of equity, the excess returns remain positive for the moment, but the future hold sthe terrifying prospect of unbridled competition from the fin tech startups.

3. Size

Are smaller companies likely to earn larger or smaller excess returns than large companies? I could tell you stories that can answer this question differently, but the answer lies in the numbers. I broke global companies down into deciles, based upon market capitalization, to see if I could eke out some answers:

Market Cap Class	Number of firms	Return on Capital	Cost of Capital	ROIC - Cost of Capital	% with +ve Excess Returns
Smallest	4,384	-8.37%	8.38%	-16.75%	9.97%
2nd decile	4,366	-9.71%	8.71%	-18.42%	14.13%
3rd decile	4,388	-3.93%	8.53%	-12.46%	20.58%
4th decile	4,399	-0.34%	8.38%	-8.72%	27.66%
5th decile	4,387	2.15%	8.32%	-6.17%	32.86%
6th decile	4,384	3.94%	8.27%	-4.33%	39.65%
7th decile	4,384	2.74%	8.07%	-5.33%	44.30%
8th decile	4,386	5.50%	8.05%	-2.55%	48.22%
9th decile	4,385	6.08%	7.90%	-1.81%	54.12%
Largest	4,385	5.75%	7.48%	-1.73%	62.24%

For proponents of small companies, the results in this table are depressing. Small companies constantly earn much more negative excess returns than large companies. In fact, the largest companies earn positive excess returns, and while I am loath to make too much of one year's results, and recognize that there is some circularity in this table (since the companies with the highest excess returns should see their values go up the most), there is reason to believe that in more and more sectors, we are seeing winner-take-all games played out, where a few companies win, and find it easier to keep winning as they get larger. The Amazon phenomenon, which has so thoroughly upended the retail business, seems to be coming to other businesses as well. It also has implications for investing, and specifically for small cap investing, where investors have historically earned a return premium. The disappearance of this small cap premium, that I have pointed to in this post, may be a reflection of the changing business dynamics.

4. Growth

The excess returns that we computed are particularly relevant when we think about growth, since for growth to create value, it has to be accompanied by excess returns. If more than 60% of companies have trouble earning their cost of capital, it follows that growth in a company is more likely to destroy value than  to add to it. If companies are taking this maxim to heart and responding accordingly, you should expect to see companies with the highest growth also have the most positive excess returns and the companies that are shrinking or have the lowest growth to be the ones that have the most negative returns. I broke companies down into deciles, based upon revenue growth over the last five years, and looked at excess returns, by decile:

Growth Class	Number of firms	Return on Capital	Cost of Capital	ROIC - Cost of Capital	% with +ve Excess Returns
Lowest Growth	2,796	1.68%	8.65%	-6.98%	10.04%
2nd decile	2,823	6.03%	8.48%	-2.46%	21.47%
3rd decile	2,814	5.60%	8.07%	-2.48%	30.79%
4th decile	2,803	6.33%	7.88%	-1.54%	36.72%
5th decile	2,815	4.93%	7.94%	-3.01%	44.19%
6th decile	2,808	6.39%	7.97%	-1.58%	49.17%
7th decile	2,816	6.44%	8.06%	-1.62%	52.35%
8th decile	2,766	6.59%	8.09%	-1.50%	53.27%
9th decile	2,850	4.13%	8.22%	-4.09%	53.76%
Top decile	2,821	9.54%	8.20%	1.33%	45.49%

There is a semblance of good news in this table. Companies in the highest growth class have the most positive excess returns, but as you can see in the table, the results are mixed as you look at the other deciles. The excess returns, in deciles six through nine are about as negative as excess returns, in deciles two through five. It behooves us, as investors, to be wary of growth in companies.

Conclusion

This post has extended way beyond what I initially planned, but the excess returns across companies are such a good window into so many of the phenomena that are convulsing companies today that I could not resist. Not only do the numbers here cast as a lie the notion that growth is always good, but they also let us see how disruption is changing businesses around the world. If there is a common theme, it is that change is now par for the course in almost every business and that inertia on the part of management can be devastating. As I look, in my next two posts, at how companies set debt ratios and decide how much to pay in dividends, where policy seems to be driven by inertia and me-toois, do keep this in mind.

YouTube Video


Data Links

1. Profit Margins, by Sector (US)
2. Profit Margins, by Sector (Global)
3. Excess Returns (ROIC-Cost of Capital and ROE - Cost of Equity), by Sector (US)
4. Excess Returns (ROIC-Cost of Capital and ROE - Cost of Equity), by Sector (Global)

Spreadsheet

1. Accounting Return Calculator

Papers

1. Return on Capital (ROC), Return on Invested Capital and Return on Equity: Measurement and Implications

Data Update Posts

1. January 2018 Data Update 1: Numbers don't lie, or do they?
2. January 2018 Data Update 2: The Buoyancy of US Equities!
3. January 2018 Data Update 3: Taxing Questions on Value
4. January 2018 Data Update 4: The Currency Conundrum
5. January 2018 Data Update 5: Country Risk Update
6. January 2018 Data Update 6: A Cost of Capital Primer
7. January 2018 Data Update 7: Growth and Value - Investment Returns
8. January 2018 Data Update 8: Debt and Taxes
9. January 2018 Data Update 9: Dividends, Buybacks and Cash Holdings
10. January 2018 Data Update 10: The Price is Right!

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January 2017 Data Update 7: Profitability, Excess Returns and Governance

If asked to describe a successful business, most people will tell you that it is one that makes money and that is not an unreasonable starting point, but it is not a good ending point. For a business to be a success, it is not just enough that it makes money but that it makes enough money to compensate the owners for the capital that they have invested in it, the risk that they are exposed to and the time that they have to wait to get their money back. That, in a nutshell, is how we define investment success in corporate finance and in this post, I would like to use that perspective to measure whether publicly traded companies are successful.

Measuring Investment Returns

The first step towards measuring investment success is measuring the return that companies make on their investments. This step, though seemingly simple, is fraught with difficulties. First, corporate measures of profits are not only historical (as opposed to future expectations) but are also skewed by accounting discretion and practice and year-to-year volatility. Second, to measure the capital that a company has invested in its existing investments, you often have begin with what is shown as capital invested in a balance sheet, implicitly assuming that book value is a good proxy for capital invested. Notwithstanding these concerns, analysts often compute a return on invested capital (ROIC) as a measure of investment return earned by a company:

This simple computation has become corporate finance’s most widely computed and used ratio and while I compute it and use it in a variety of contexts, I do so with the recognition that it comes with flaws, some of which can be fatal. In the context of reporting this statistic at the start of last year, I reported my ROIC caveats in a picture:

Put simply, it would be unfair of me to tar a young company like Tesla as a failure because it has a negative return on invested capital, and dangerous for me to view HP as a company that has made good investments, because it has a high ROIC, since is only due to the fact that it has written off almost $16 billion of mistakes, reducing its invested capital and inflating its ROIC. I compute the return on invested capital at the start of 2017 for each company in my public company sample of 42,668 firms, using the following judgments in my estimation:

I do make adjustments to operating income and invested capital that reflect my view that accounting miscategorizes R&D and operating leases. I am still using a bludgeon rather than a scalpel here and  the returns on invested capital for some companies will be off, either because the last year’s operating income was abnormally high or low and/or accountants have managed to turn the invested capital at this company into a number that has little to do with what is invested in projects. That said, I have the law of large numbers as my ally.

Measuring Excess Returns

If the measure of investment success is that you are earning more on your capital invested than you could have made elsewhere, in an investment of equivalent risk, you can see why the cost of capital becomes the other half of the excess return equation. The cost of capital is measure of what investors can generate in the market on investments of equivalent risk. Thus, a company that can consistently generate returns on its invested capital that exceed its cost of capital is creating value, one that generates returns equal to the cost of capital is running in place and one that generates returns that are less than the cost of capital, it is destroying value. Of course, this comparison can be done entirely on an equity basis, using the cost of equity as the required rate and the return on equity as a measure of return:

In general, especially when comparing large numbers of stocks across many sectors, the capital comparison is a more reliable one than the equity comparison. My end results for the capital comparison are summarized in the picture below, where I break my global companies into three broad groups. The first, value creators, includes companies that earn a return on invested capital that is at least 2% greater than the cost of capital, the second, value zeros, includes companies that earn within 2% (within my estimation error) of their cost of capital in either direction and the third, value destroyers, that earn a return on invested capital that is 2% lower than the cost of capital or worse. 

The public market place globally, at least at the start of 2017, has more value destroyers than value creators, at least based upon 2016 trailing returns on capital. The good news is that there are almost 6000 companies that are super value creators, earning returns on capital that earn 10% higher than the cost of capital or more. The bad news is that the value destroying group has almost 20,000 firms (about 63% of all firms) in it and a large subset of these companies are stuck in their value destructive ways, not only continuing to stay invested in bad businesses, but investing more capital.

If you are wary because the returns computed used the most recent 12 months of data, you are right be. To counter that, I also computed a ten-year average ROIC (for those companies with ten years of historical data or more) and that number compared to the cost of capital. As you would expect with the selection bias, the results are much more favorable, with almost 77% of firms earning more than their cost of capital, but even over this much longer time period, 23% of the firms earned less than the cost of capital. Finally, if you are doing this for an individual company, you can use much more finesse in your computation and use this spreadsheet to make your own adjustments to the number.

Regional and Sector Differences
If you accept my numbers, a third of all companies are destroying value, a third are running in place and a third are creating value, but are there differences across countries? I answer that question by computing the excess returns, by country, in the picture below:

Link to live map

Just a note on caution on reading the numbers. Some of the countries in my sample, like Mali and Kazakhstan have very few companies listed and the numbers should taken with a grain of salt. Breaking out the excess returns by broad regional groupings, here is what I get:

Spreadsheet with country data

Finally, I took a look at excess returns by sector, both globally and for different regions of the world, comparing returns on capital on an aggregated basis to the cost of capital. Focusing on non-financial service sectors, the sectors that delivered the most negative and most positive excess returns (ROIC - Cost of Capital) are listed below:

Spreadsheet with sector data

Many of the sectors that delivered the worst returns in 2016 were in the natural resource sectors, and depressed commodity prices can be fingered as the culprit. Among the best performing sectors are many with low capital intensity and service businesses, though tobacco tops the list with the highest return spread, partly because the large buybacks/dividends in the sector have shrunk the capital invested in the sector.

For investors, looking at this listing of good and bad businesses in 2017, I would offer a warning about extrapolating to investing choices. The correlation between business quality and investment returns is tenuous, at best, and here is why. To the extent that the market is pricing in investment quality into stock prices, there is a very real possibility that the companies in the worst businesses may offer the best investment opportunities, if markets have over reacted to investment performance, and the companies in the best businesses may be the ones to avoid, if the market has pushed up prices too much. There is, however, a corporate governance lesson worth heeding. Notwithstanding claims to the contrary, there are many companies where managers left to their own devices, will find ways to spend investor money badly and need to be held to account.

What next?

I am not surprised, as some might be, by the numbers above. In many companies, break even is defined as making money and profitable projects are considered to be pulling their weight, even if those profits don’t measure up to alternative investments. A large number of companies, if put on the spot, will not even able to tell you how much capital they have invested in existing assets, either because the investments occurred way in the past or because of the way they are accounted for. It is not only investors who bear the cost of these poor investments but the economy overall, since more capital invested in bad businesses means less capital available for new and perhaps much better businesses, something to think about the next time you read a rant against stock buybacks or dividends.

YouTube Video


Spreadsheet

1. ROIC Calculator

Datasets

1. Excess Returns, by Country- January 2017
2. Excess Returns, by Industry - January 2017

Data 2017 Posts

1. Data Update 1: The Promise and Perils of Big Data
2. Data Update 2: The Resilience of US Equities
3. Data Update 3: Cracking the Currency Code - January 2017
4. Data Update 4: Country Risk and Pricing, January 2017
5. Data Update 5: A Taxing Year Ahead?
6. Data Update 6: The Cost of Capital in January 2017
7. Data Update 7: Profitability, Excess Returns and Corporate Governance- January 2017
8. Data Update 8: The Debt Trade off in January 2017
9. Data Update 9: Dividends and Buybacks in 2017
10. Data Update 10: The Pricing Game

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