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Earnings growth....long term, is the rest just all noise?

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June 05, 2013 – Comments (26)

So often when people analyze financial statements and earning reports, there are many things that are looked at.  ROIC to see how well the company is employing capital.   Debt ratios to see liquidity.  Margins to see how the company would be able to handle a recession or inflation.Organic growth, book value, etc.  Then there are things besides the statements themselves, such as "I have used their product and it is fantastic".  Also, things like "the CEO pays himself too much and uses too much company money to buy stupid things like private jets, etc." My question is, long term, why does anything besides earning growth matter?

Lets look at the things I mentioned individually

 

ROIC- well if a misuse of capital leads to slower earnings growth, then just look at the earnings growth.

Margins- if a company was long term able to maintain a small profit margin and still grows, what does the margin matter?  If the company has survived recession and inflationary times with a low margin, then the fear should be taken away that low margins could spell trouble.

Debt ratios- if a company has a lot of debt and always has but still has managed to grow earnings with that, why does it matter how much debt they have?  They clearly are able to manage it without negatively affecting them.

Book value- why does the book value matter?  All I care about is how much the company is paying me.  I don't cae if the company has a book value of zero, so long as they are able to keep earning me more and more money.

 

Organic growth- why do I care where the growth is coming from?  As long as the earnings keep growing, and I have a stake of those earnings, I don't care if it is organic or inorganic...just keep paying me more. 

 

Fantastic product- If the product is fantastic, then a lot of people will buy it, so it will be reflected in the earnings.  If the product is terrible, then the product won't sell and it will be reflected in earnings.  If the opposite is true, maybe your definition of terrible or fantastic is not the same as other consumers.

 

Corrupt management-  if they are able to waste a ton of company money and STILL produce great earnings growth, then obviously their corruption is not affecting my bottom line.

 

So what I am trying to say, is that I DO BELIEVE that in order to have long term earnings growth, you need good management, you need a good product, you need organic growth, you need manageable debt, you need high margins, you need high ROIC, (I still think book value is irrelevant).  But if you HAVE all of those things, then you should also have good earnings growth.  And if you don't have all of those things, you probably wont have good earnings growth.  So why not just skip all that and look at long term earnings growth?  Unless you suspect fraud, which is a completely different subject.  If my ownership in a company is my stake on earnings, then just increase my earnings constantly.....all the rest is just noise.

I am not saying I am right or wrong, but in my head I can't see why the rest matters.  I get it for a new company that has not been through recession or high inflation....you maybe use those metrics to determine how they would be able to handle it. But one that has been around through many types of economic situations and just keeps growing earnings, does the rest matter?

 

Thanks in advance for the replies. 

26 Comments – Post Your Own

#1) On June 05, 2013 at 3:08 PM, JohnCLeven (76.91) wrote:

I think Keynes said “It is better to be roughly right than precisely wrong"?

I think you're roughly right: In the long run earnings growth is what it all boils down to.

The 2nd part, which hasn't been mentioned, would be the price paid for those future earnings.

 

From the 2000 Berkshire Hathaway (BRKaShareholder Letter:

“…Aesop and his enduring, though somewhat incomplete, investment insight was ‘a bird in the hand is worth two in the bush.’ To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? [What is the probability that your growth predictions will "roughly right?" How well do you know the business. and it's competitive advantages? (or lack thereof?)] When will they emerge and how many will there be?" [What are the range of your predictions for earnings growth between x% and x% of the next x years?] "What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush — and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.

Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota — nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe."

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#2) On June 05, 2013 at 3:22 PM, somrh (83.91) wrote:

A couple of quick comments.

Debt ratios matter for risk aspects. If earnings are equal between two companies and one is riskier than the other, which one would you rather have? 

ROIC - This one actually matters quite a bit. Because earnings growth comes at a cost. Typically, in order to achieve growth, a company either has to reinvest earnings from profits or invest from financings (debt/equity issuance).

So it actuallly matters how much capital costs and what return can be achieved from that capital.

If ROIC < Cost of equity, growth will destroy value

Example:

Consider two companies: Quality and Junk. Assume both are selling require a 10% cost of capital.

Quality:
$100 Invested Capital
20% ROIC
$20 Earnings

Junk:
$400 Invested Capital
5% ROIC
$20 Earnings

Suppose we want to achieve 5% earnings growth (e.g. earnings increase by $1) for both companies.

In order for Quality to achieve 5% growth, it would need to invest $5 (since it earns 20% return on capital: 20%x$5 = $1). That means that Quality could distribute to its owners $15 of its profits and still grow earnings at 5%.

In order for Junk to achieve that same 5% growth, it would need to invest all $20 in earnings to achieve that same $1 in profit growth (5%x$20). 

But since cost of capital for Junk is 10% and it's reinvesting that at 5%, it's actually destroying value. (Consider taking out a personal loan and investing that money in treasuries.)

Junk would do shareholders much better distributing all of its earnings to its shareholders (or liquidating its assets assuming it can sell them at a reasonable price.)

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#3) On June 05, 2013 at 3:49 PM, Mega (99.97) wrote:

Future earnings growth is a primary determinant of value. But that doesn't mean that past earnings growth is the only metric to look at when predicting future earnings growth. In fact, studies show ROIC is more persistent over time, and I think probably more effective at predicting future earnings growth.

I agree with somrh's thoughts. I look at the balance sheet primarily for potential downside. Occasionally, the market price is so out of whack that upside is visible based on liquid assets.

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#4) On June 05, 2013 at 4:02 PM, elcid24 (63.29) wrote:

http://caps.fool.com/Blogs/high-marginsgood-over-time/761582?&mrr=1.00

See Comment #4, #6.

http://www.gsm.pku.edu.cn/resource/uploadfiles/docs/20120710/2012071001255625564651.pdf

Check out chapter 2, page 17. 

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#5) On June 05, 2013 at 6:49 PM, Valyooo (99.55) wrote:

There are only two comments on that blog

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#6) On June 05, 2013 at 7:30 PM, awallejr (81.36) wrote:

Well my opinion in this link comment #11:

http://caps.fool.com/Blogs/why-wont-the-pundits-take/829774

Also link in comment #18 is an interesting read.

But doing any real DD on any company would require considering several metrics, some of which were mentioned here.  Another metric I like is "free cash flow."

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#7) On June 05, 2013 at 9:23 PM, Valyooo (99.55) wrote:

awalle

do you like mlp, bdcc, reits etc in all environemtns, or just this one? 

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#8) On June 06, 2013 at 12:25 AM, awallejr (81.36) wrote:

Mainly this one.  It depends on the interest rates.  In the late 70's early 80's cash really was best. Money market accounts gave you double digit returns.  Since I do not see interest rates rising anytime soon (ignore the tapering noise, what matters is interest rates), best place for yield is in the stock market.  Mlps and some bdcs and reits have a double advantage with their tax treatment.

They are correcting which is a great buying opportunity.  Fewer dollars gets you a higher income stream.  At your age you should be concentrating on 3 things.  Build a core income stream and grow it.  Buy speculative stocks since you are young enough to endure the losses.  And buy outright quality.

From what you said elsewhere it looks like you are doing that.

 

 

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#9) On June 06, 2013 at 12:57 AM, awallejr (81.36) wrote:

As a P.S., what I mean by interest rates is the FED interest rates.  You can always see short term mortgage and corporate rate spikes which you are seeing now.  But until the FED starts to raise things short term is short term.

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#10) On June 06, 2013 at 1:18 AM, portefeuille (99.60) wrote:

In the late 70's early 80's cash really was best.

Or stuff like AMGN shares.



enlarge

Split adjusted low on Nov 19, 1984: ≈ $0.0756
Split adjusted high on Apr 23, 2013: ≈ $114.95 (+151900%, i.e. $1k -> $1.52M + some dividends ;)).

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#11) On June 06, 2013 at 1:51 AM, valuemoney (99.99) wrote:

 In the late 70's early 80's cash really was best.

Not true. Stocks were the best to be in. Look at earnings yield on the S&P. Ask Buffett if you don't believe me or just look at Berkshires returns then. Here is how it works. In 1977 the earnings yield on the S&P was 11.43 then as follows 78 and so on....12.11, 13.48, 11.04, and 12.39 in 1981 and here is the kicker. YOU HAD A roughly 39.65% gain on earnings ON top of those yields! Earnings went from 10.87 in 77 to 15.18 in 1981.  

When interest rates are high asset prices are usually lower.

When interest rates are low asset prices will be higher.

Any guesses what will happen when the FED ends QE? I would bet the market goes down. Why? Money will stop being so easy. How do you stop inflation or slow the economy? Raise interest rates. Slow the flow of money. It is no fluke since early to mid 80"s when interest rates peaked then till now the market has went from 140 to a high of 1687 last month. Rates will rise and it will be a drag on stocks.

l would also add NEVER buy speculative stocks. You NEVER want losses. That don't make sense. The sentence even says. Buy speculative stocks since you are young enough to endure the losses. It is true if you buy spec stocks you will probably have losses. I say buy companies just as you state in this blog. High ROIC. Chase earnings and earnings yield. Why buy a spec stock if it has no or poor earnings? You don't need big winners if you are young......... just consistent winners and no big losers.

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#12) On June 06, 2013 at 1:53 AM, valuemoney (99.99) wrote:

Good blog BTW.

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#13) On June 06, 2013 at 2:59 AM, somrh (83.91) wrote:

@Valyooo , @elcid24

There are 8 comments on your blog. And I didn't know where that book was online. 

In any event, I forgot to get to the conclusion to my original reply. 

So we have Quality and Junk and both are currently earning $20. Assuming no growth and the 10% cost of capital, they both should be valued at $200.

Now watch what happens when growth gets factored in. 

This formula is based on the Gordon Growth Model.  The full derivation is in CH2 of the book (noted above).

V = Invested Capital x (ROIC - Growth) / (WACC - Growth)

So if you assume 5% growth for each company here's the value:

Quality:

V = $100 x (20% - 5%) / (10% - 5%) = $300

Junk:

V = $400 x (5% - 5%) / (10% - 5%) = $0

The moral is that Quality, with its high return on capital, actually increased in value due to growth ($200 -> $300). This is because its return on capital is greater than cost of capital.

Junk on the other hand went from $200 to $0. Growth made it entirely worthless. Junk is better off not reinvesting in its business (and perhaps liquidating its assets.

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#14) On June 06, 2013 at 11:17 AM, awallejr (81.36) wrote:

Yes Porte, owning equities longterm can always pan out. 

Value you are comparing longterm to short term regarding cash.  The market sucked in late 70s early 80s.  It didn't start to take off until the FED started lowering their interest rate.  But from a longterm point of view equities have been the place to be.

And young people should always do some speculating.  You don't hit homeruns without swinging for the fence once in a while.  Many start up companies are speculative, but they can turn into a Google, Microsoft or Apple.

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#15) On June 06, 2013 at 12:00 PM, Valyooo (99.55) wrote:

Somrh,

 

if value and junk both have $20 in earnings in year 5 and are both worth $200....ok. Then in year 15 they both have $60 earnings. Junk is worth $0 with $60 in earnings?

 

awalle,

phillosophically why is yield better than capital appreciation? Also do you still like silver and if so why? I think the precious metal bull might be over 

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#16) On June 06, 2013 at 12:12 PM, JaysRage (90.16) wrote:

In a way, yes, but projecting continued earnings growth without understanding how you got the current growth is potentially buying into false hope.   Ultimately, investing is about FUTURE earnings growth, not PAST earnings growth.....if the reasons are not understood......PAST earnings growth does not guarantee FUTURE earnings growth.  

A lot of the earnings growth over the past few years have been due to companies stream-lining and creating process efficiencies, not due to wild revenue expansion or sustainable growth.   Companies are earning the right to grow in a sustainable way, but not too many of them are.   A lot of companies are cautious about expanding payrolls to grow in a sustainable way.   There isn't much more waste to squeeze out of most companies, so we're in to "real growth or stall" mode.  It's actually a pretty important point in the recovery right now.  

The current stock market has built in that recent earnings growths will continue into the near future, yet it's difficult to see an engine that can sustain that.

There are exceptions......of course.....Amazon and Google continue to invest and grow for real.    There are others, of course....but the list is pretty small for the big guns.    

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#17) On June 06, 2013 at 12:38 PM, Valyooo (99.55) wrote:

Another way to look at that would be tat companies are growing even in a bad economy so think of how good earnings will be in a good economy

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#18) On June 06, 2013 at 1:34 PM, somrh (83.91) wrote:

@ Valyooo,

The model gives the present value of the asset and assumes that it will grow at 5% in perpetuity (an unrealistic assumption of the model). In order for Junk to grow at 5% it has to reinvest all of its earnings; it will never pay any dividends. 

But let's suppose it grows for 20 years and then stops growing (paying out all of its earnings as dividends at the end of 20 years).

It will actually have $20 x 1.05^20 = $53 in earnings 20 years from now.

At a 10% discount rate, Junk would be worth $530 in the future. But how much should you pay (in the present) for $530 in the future to get a 10% rate of return?

The answer is about $79 which is still a lot less than the $200 it would have been worth had it not grown.

So in this scenario the conclusion remains the same. Junk is worth more by paying out all of its earnings in dividends (or liquidating) than if it were attempt to grow at such a low rate of return. 

Also keep in mind if this scenario was applied to Quality as well, Quality would be worth $530 in 20 years but you would have also received $15 in dividends growing at 5% per annum.  

Quality would be worth the present value of the dividend stream plus the present value of the terminal value ($530) or:

Quality = $191 (PV of dividends) + $79 (PV of terminal value) = $270

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#19) On June 06, 2013 at 2:39 PM, Valyooo (99.55) wrote:

I get that.  But I am assuming that both companies either pay the same dividends or no dividends.  Therefore what I am saying is if they pay the same dividends and still grow earnings the same amount, its all the same.  This likely can only be achieved through high ROIC, but either way, just seems like you can bypass that part and just look at dividend + earning growth

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#20) On June 06, 2013 at 5:44 PM, somrh (83.91) wrote:

If you're referring to the fact that your returns are going to be a combination of dividends and growth (and multiple expansion reversion) such as Hussman's simple model than sure.

The problem is you're really interested in future earnings growth.  What determines that? How do you predict that?

That's why a lot of those other things matter. ROIC, for many business models, places an upper limit on growth. You can't grow your earnings faster than your return on capital.

So let me ask this: How would you predict future earnings growth without looking at all of those other things? Or is just looking at past earnings growth is sufficient?

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#21) On June 06, 2013 at 5:48 PM, awallejr (81.36) wrote:

awalle,

phillosophically why is yield better than capital appreciation? Also do you still like silver and if so why? I think the precious metal bull might be over

I am all for both, but I like creating an income generating core first.  The main reason is so I don't have to sell things to buy things. Every month I generate income which I then reinvest.  By having this income I could take advantage of this recent correction.  I make it a point to buy something at least once a month with this income.  I never need to add to my portfolio.

It is kind of what Buffett does. Every year BRK's investments generate cash which he then re-deploys.  The "great" Goldman Sachs and GE had to go hat in hand to him for cash during the crash.

Another way I generate income is by selling far out puts on companies I like.  I am basically getting an interest free loan off my margin.  I do cap my commitment to no more than 50% margin availability at the maximum (learned that from the '08-'09 crash), and I avoid debt heavy no free cash flow companies (learned that from ATPG) .

As for silver/gold, I am a perma fan of them, but I like the coins since they have numismatic value as well as melt value.  I basically view this as the cost of having "insurance" since I can't predict what things will be like 15-20 years out.  Also it is neat holding these old coins in hand.  I've been buying 1899-1914 non restrike 20 franc french "rooster" coins.  Apmex sells them for less than $30 over melt.

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#22) On June 06, 2013 at 5:51 PM, DrGoldin (99.66) wrote:

People invest for the FUTURE of a stock, not its PAST.  Sure, everybody wants long-term growth, and companies with a great long-term history of growth are usually solid investments.  But ... not always.  Past performance is no guarantee of future results, as they always say.  And that's why people look at other indicators, such as debt ratios, margins, top-line vs. bottom-line growth, etc.: that kind of data gives a fuller picture of what to expect from the company in the future.  If a company with a good long-term history of growth suddenly encounters declining margins, it's a sign that something is going on: something that will have to be addressed if the company is going to remain profitable.

 

So ... yeah, at the end of the day, earnings are all that matter, but we want future earnings, not past earnings.

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#23) On June 06, 2013 at 6:09 PM, Valyooo (99.55) wrote:

Yeah but you see, what if you look at a stock you own and they report earnings and you look and go "wow, growth was great...but roic sucked, their future earnings might suck".  If tey were able to grow earnings very nicely in the past with roic that was not good, why would they not be able to do the same in the future?  Why would they stop being able to in the future?

Don;t forget I am recognizing it is hard to grow sustainably with low ROIC.  But if long term growth is only acheivable with long term ROIC, it seems redundant to look at both. 

 

On a seperate note, why would ROIC stay the same over time?  (Seperate argument) 

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#24) On June 06, 2013 at 6:12 PM, awallejr (81.36) wrote:

I never need to add to my portfolio. 

What I meant by this is from outside accounts.  I always add with profits and income from my portfolio.

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#25) On June 07, 2013 at 2:31 PM, somrh (83.91) wrote:

@Valyooo

I'm not sure what you have in mind. Are you saying that earings increased at a good rate but ROIC declined?

The only way I can see that happening is if they significantly added to invested capital. That would suggest that they recenty made a large investment and it did not perform well. That could very well be a bad sign. 

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#26) On June 08, 2013 at 4:02 PM, Valyooo (99.55) wrote:

Well what I am saying is, high ROIC is probably the only way to sustain earnings growth long term (forgetting distributions vs reinvestment for a moment), so looking at both is probably redundant, so just focus on the earnings growth

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