In my piece yesterday on understanding return on equity, I explained that companies that are able to deliver high returns on equity for a sustained period find themselves in an enviable position. Profits do matter, but the ability to redeploy those profits at above-market rates of return really excites investors.
I illustrated the straightforward cases of Microsoft
Five ways ...
To improve returns on equity, companies need at least one of the following:
- Higher turnover, i.e., sales
- Cheaper leverage
- More leverage
- Lower taxes
- Wider margins on sales.
Any one of the above will improve return on equity. Of the five factors, companies have the least control over tax levels, although management can certainly use creative accounting to temporarily alter the tax rate. An investor is better advised to focus on the other four. The ability to spot improved sales, prudent use of leverage, or cost-cutting initiatives can lead you to an attractive investment opportunity.
Sell more, make more
There's no secret here. All else equal, an increase in sales should create an increase in profits. Of course, the sales quality should be examined. As sales increase, accounts receivable should naturally follow suit. However, if receivables are consistently growing much faster than sales, there may be troubles when it's time to collect. Increased sales that lead to higher profits yield higher returns on equity capital.
When employed prudently and wisely, the use of leverage, or debt, can increase returns on equity. Similarly, if a business can lower its cost of debt, the corresponding effect is a higher return on equity. Unfortunately, most financial companies missed this lesson badly this year.
Aside from Goldman Sachs
The painful lesson is similar to buying stocks on margin. If you are leveraged five to one, a 10% return on the leveraged portfolio equals a return on equity of 50%. The same (negative) return on equity goes for a 10% loss. Unfortunately, most businesses fail to use leverage appropriately and opportunistically, and use leverage at alarming multiples to equity. The results, as we all know, have been disastrous.
Again, the idea here is to squeeze as much profit out of existing sales as possible. This is achieved in one of two ways: increase prices or decrease costs. Very few companies can raise prices without incurring competition or meaningful declines in volume. Two prominent companies that can are Coca-Cola
The generalizations are simple, but they cover the levers of profitability regarding this metric. Understanding how they each operate inside a business can give you insights into that firm's ability to earn above-market rates of return for prolonged periods of time.
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Microsoft, Dell, and Coca-Cola are all Inside Value recommendations. Wrigley is an Income Investor recommendation. Dell is also a Stock Advisor pick.