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Archive for the ‘Earnings Growth and Profitability’ Category

In my last post I said that if a business’s ROIC has been, or is, greater than my discount rate, I think the business is likely to be viable. I also said it means that any growth by the business is likely to be profitable for me. In this post I am going to explain why a business’s ROIC tells me if its earnings growth will be profitable.  

How a business grows its earnings

Earnings growth by a business normally needs the business to grow its assets (for example inventory, receivables, plant and equipment and intangibles). The business usually has to pay for most of these new assets by using new capital.[1] This new capital must come from either retained earnings or new capital raised from shareholders (that’s me if I am an investor) or new borrowings. The owners of this new capital will have to be paid a return for providing the capital.[2]  

How a business’s ROIC tells me if its earnings growth will be profitable

A business’s earnings growth will only be profitable to me if the business earns more on these new assets than the minimum return I need to provide the capital (my discount rate). For example, when a business’s ROIC is equal to my discount rate, asset growth by the business will have no value to me because the return the business will earn on the new capital will just equal the opportunity cost to me for letting the business use my capital. Thus, while the business has increased in size, simply because it has more assets, the net return to me is zero.

When a business’s ROIC is lower than my discount rate, asset growth by the business will actually destroy value for me. This is because the business earns less on the new assets than the opportunity cost to me for letting the business use my capital.

Only when a business’s ROIC is higher than my discount rate is asset growth by a business profitable to me. It will be profitable because the business earns more on the new assets than the opportunity cost to me for letting the business use my capital. As a shareholder, I will receive these additional earnings. I will receive these additional earnings directly, either by dividends, or indirectly, by the business increasing in value because it has retained all or part of these earnings.[3]  

This is a very important point for investors to understand. Many investors think earnings growth by a business is unambiguously good. It is not. In many cases earnings growth will reduce the business’s value.  


[1] Some of the asset growth will usually be funded by a growth in spontaneous liabilities. Spontaneous liabilities are liabilities such as accounts payable, wages payable, accrued expenses, and accrued taxes. 

[2] For an excellent discussion of this process see, ‘Value Investing: From Graham To Buffett And Beyond’, Bruce Greenwald et al, 2001.  

[3] For an excellent discussion of this issue see, ‘Value Investing: From Graham To Buffett And Beyond’, Bruce Greenwald et al, 2001.

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