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 (NASDAQ:MSFT) and Dell (NASDAQ:DELL), two businesses that were earning abnormally high rates of return on equity capital. For years, they were able to redeploy the excess capital at similar rates of return. Take $1 million, then compound it at 30% to 40% for eight to 10 years, and you'll have an idea of what I mean. Then consider companies that can do this with billions to appreciate what Microsoft did during its formative years.
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.
Oh, leverage
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 (NYSE:GS), which has so far managed to ride out the credit storm relatively unscathed, a lot of financial companies are being hurt twice. First, because liquidity is drying up; and second, because they've used leverage to increase returns for years now.
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.
Wider margins
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 (NYSE:KO) and Wrigley (NYSE:WWY). Not many people are willing to save a dime in order to put an inferior product in their mouths. As a result, Coke and Wrigley have enjoyed decades of high returns on equity.
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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