In today’s Money Morning…how useful are earnings?…return on equity…who owns return on equity?…eearnings, ROE, cash flow and stock returns… and more…
How to analyze companies? And how to proceed to analyze the actions?
As investors, we can distill these questions into something more direct: what predicts good stock market returns?
Let’s look at some potential answers here.
What is the use of earnings?
The income statement is probably the most consulted financial statement, both by the financial press and by analysts.
And net income is one of the most common numbers when analyzing companies…not to mention that net income is half of the ubiquitous P/E ratio.
But how useful are earnings in analyzing a stock and its prospects?
Often profits can be “managed”, “smoothed” or “adjusted” by executives in a corporate version of catfishing.
The malleable nature of earnings leads some analysts to focus on cash flow, which some view as more grounded in reality.
In 2017 Journal of Financial Analysts noted paper:
‘Although the income statement has long been central to financial statement analysis, well-documented shortcomings call into question the effectiveness of relying on its components to value stocks and predict stock returns. Notable bankruptcies, including those of Enron and WorldCom, graphically illustrate that profitable GAAP income statements can coexist with negative operating cash flow or free cash flow for the same company for long periods of time.
‘Specifically, we believe that current GAAP requirements permit too many other types of financial statement presentation; this information is too aggregated and may be presented inconsistently, making it difficult for users to understand the relationship between the way accounting information is presented and the underlying economic results of the business. Novy-Marx’s (2013) intuition in this area certainly rings true: the further down one goes in the income statement, the more the measures of profitability become “polluted” and less linked to “true” economic profitability.‘
But the Enrons and WorldComs of the corporate world are outliers, infamous precisely because of the irregularity, improbability, and scale of deception.
In the vast majority of cases, income is reported fairly based on reasonable assumptions, which provides useful information.
One way to use earnings intelligently is to assess a company’s return on equity.
Return on equity
One of the most useful ways to analyze stocks and predict their performance is to calculate a stock’s return on equity (ROE).
ROE is a measure of a company’s earnings against the shareholders’ funds employed during the year.
ROE can help disentangle the question of which is more important — a company’s performance in absolute terms or its assess back.
Let’s take two companies. Company A made a profit of $150 million last year. Company B won $15 million.
Looking at just that, we could deduce that Company A is a more interesting prospect.
But what if you found out that Company A had $10 billion in equity while Company B only had $100 million?
The former returned a measly 1.5% on equity; the latter 15%.
We can consider it differently.
Suppose you want to buy a coffee business for cash.
Would you like to buy a business earning 15% per year on your investment or 1.5%?
As John Tennent wrote in his Cash management guide (emphasis added):
‘It is not the amount of money a business has in its bank accounts that will make it successful; the role of management is to generate a financial return on business activities that is significantly higher than what an investor can obtain from other less risky investments as a deposit account. Holding cash will not help achieve this goal. Management’s objective is therefore to build a company capable of generating sustainable cash flow and offering a superior return on investment to investors.‘
A famous investor uses return on equity analysis to pick stocks.
Books by Mary Buffett, Brian McNiven, and Richard Simmons describe Buffett’s emphasis on ROE at length.
Take Simmons’ book, Buffett: step by step.
In it, Simmons states:
‘Almost all of Buffett’s stock investments can be summed up as follows: they are growing companies that can reinvest capital at very attractive rates of return.
‘Sincerely Buffett [ROE] as a central measure of financial well-being.‘
Buffett’s record speaks for itself, but his record is one of thousands.
Does the ROE method have wider validity?
We’ll get to that in a moment, but whether ROE has broader validity or not, it certainly has detractors.
What return on equity?
Not everyone is enamored with ROE as the primary measure of financial performance.
Financial analyst and author George C Christy, for example, thinks it’s wrong to focus on ROE because it emphasizes the wrong kind of return:
In his book, Free cash flow: seeing through the accounting fog machine, Christy writes:
‘Most “how to invest” books recommend return on equity as a good measure of financial performance. The use of the word return in this ratio is extremely erroneous. Who is this ratio supposed to account for? Certainly, a company’s return on its investments is nowhere to be found in its return on equity ratio. With the exception of stocks used to make acquisitions, business investments are made with cash and return results are measured by cash flow.
‘Whatever the net income and equity are, they are not cash figures. How can return on equity, by any stretch of the imagination, relate to investor return? We have already pointed out that investor return is not a function of net income, book values or book estimates. The return to the investor is a function of the net difference between the cash invested and the cash received from the investment.‘
Christy even enlisted Buffett to her cause, arguing that the Oracle of Omaha really only focuses on cash flow, not ROE.
According to Christy, ‘Warren Buffett uses cash flow to value companies he wants to buy.‘
Earnings, ROE, cash flow and stock returns
This can all get a bit confusing.
So what does empirical research have to say about ROE, earnings, and cash flow as predictors of stock performance?
Krishna Palepu has summarized some findings on the matter in his Business analysis and valuation:
‘The researchers examined the value of earnings and return on equity (ROE) by comparing the stock returns that could be earned by a hypothetical investor who has a perfect forecast of earnings, return on equity (ROE) and cash flows. business cash flow for the following year. To assess the importance of profits, the hypothetical investor is assumed to buy shares of companies whose profits increase for the next year and sell shares of companies whose profits decrease thereafter. If this strategy is followed consistently, the hypothetical investor would have earned an average return of 37.5% per year over a 40-year period. If a similar investment strategy is followed using ROE, buying stocks with subsequent ROE increases and selling stocks with ROE decreases, an even higher annual return of 43% would be achieved. In contrast, cash flow data seems to be of much less value than earnings or ROE information. The annual returns generated by buying shares with an increase in subsequent cash flow from operations and selling shares with a decrease in cash flow would be only 9%. This suggests that next period earnings and ROE performance are more relevant information for investors than cash flow performance.‘
But the issue becomes a bit more nuanced when you disaggregate cash flow.
The 2017 Journal of Financial Analysts The article I mentioned earlier analyzed free cash flow data as a measure of profitability and stock market returns.
Here are the conclusions (emphasis added):
‘From an investment perspective, investors may be able to obtain better information about investment prospects and hence future stock returns in rrelying on cash flows that disaggregate operating cash flows from financing, tax, investing, non-operating and non-recurring activities rather than relying on profit and loss measures of profitability. Although “quality investment” strategies based on various fundamental criteria have recently gained notoriety, our research suggests that analysts and investors better follow the money.‘
What can we learn from all of this?
In my opinion, investing is more of an art than a science. Therefore, pursuing the single formula or metric that can predict superior returns is futile.
But you can arm yourself with solid principles.
Principles such as “focus on companies with consistently high ROE” or “follow cash: free cash flow matters just as much as profits”.
Financial metrics should not end your inventory analysis, but initiate it.
For silver morning