In today’s Money Morning…how useful are earnings?…return on equity…whose return on equity?…earnings, ROE, cash flows, and stock returns…and more…
How should we go about analysing businesses? And how should we go about analysing stocks?
As investors, we can distil these questions into something more direct — what are the predictors of great stock returns?
Let’s delve into some potential answers here.
How useful are earnings?
The income statement is probably the financial statement consulted most — by the financial press and analysts alike.
And net income is one of the most common figures bandied about when analysing companies…not to mention that net income is one-half of the ubiquitous P/E ratio.
But how useful are earnings in analysing a stock and its prospects?
Often, earnings 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 flows, which some consider more grounded in reality.
As a 2017 Financial Analysts Journal paper noted:
‘Although the income statement has long been at the centre of financial statement analysis, well-documented shortcomings call into question the efficacy of relying on its components to value stocks and predict stock returns. Notorious bankruptcies, including Enron and WorldCom, graphically illustrate that profitable GAAP income statements can coexist with negative operating or free cash flows for the same company for long periods.
‘More specifically, we believe that existing GAAP requirements permit too many alternative types of financial statement presentations; such information is too aggregated and can be inconsistently presented, making it difficult for users to understand the relationship between how accounting information is presented and the underlying economic results of the company. Novy-Marx’s (2013) intuition in this area certainly rings true: The farther down the income statement one goes, the more “polluted” profitability measures become and the less related to “true” or economic profitability.’
But the Enrons and WorldComs of the corporate world are outliers, infamous precisely because of the irregularity, improbability, and scale of the deception.
In the vast majority of cases, earnings are reported faithfully under reasonable assumptions, providing useful insights.
One way to insightfully use earnings is to assess a firm’s return on equity.
Return on equity
One of the most useful ways to analyse stocks and anticipate stock performance is by calculating a stock’s return on equity (ROE).
ROE is a metric pitting a firm’s profits against the shareholder funds employed during the year.
ROE can help in untangling the question of what’s more important — a business’s return in absolute terms or its rate of return.
Consider two companies. Company A made $150 million in profit last year. Company B made $15 million.
Looking at only this, we might infer Company A is a more worthwhile prospect.
But what if you then found out 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 another way.
Say you wanted to buy a cafe business outright in cash.
Would you want to buy a business earning 15% a year on your investment or 1.5%?
As John Tennent wrote in his Guide to Cash Management (emphasis added):
‘It is not the amount of cash that a business has in its bank accounts that will make it successful; the role of management is to generate a financial return on the business activities that is substantially greater than an investor can achieve from other less risky investments such as a deposit account. Holding cash will not help achieve this objective. The focus of management is therefore to build a business that can generate a sustainable cash flow and deliver a superior return on investment for investors.’
One famous investor uses return-on-equity analysis to pick stocks.
Warren Buffett.
Books by the likes of Mary Buffett, Brian McNiven, and Richard Simmons profile Buffett’s focus on ROE at length.
Take Simmons’ book, Buffett: Step by Step.
In it, Simmons declares:
‘Almost all of Buffett’s equity investments can be summed up as follows: they are growing companies that can reinvest capital at highly attractive rates of return.
‘Buffett regards [ROE] as the central measure of financial well-being.’
Buffett’s record speaks for itself, but his record is one among thousands.
Does the ROE method have wider validity?
We’ll get to that in a bit, but whether ROE has wider validity or not, it sure has detractors.
Whose return on equity?
Not all are enamoured with ROE as a top measure of financial performance.
Financial analyst and author George C Christy, for instance, thinks a focus on ROE is misguided, as it emphasises 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 measurement of financial performance. The use of the word return in this ratio is egregiously misguided. Whose return does this ratio supposedly capture? Certainly a company’s return on its investments is nowhere to be found in its Return on Equity ratio. Except for stock shares used to make acquisitions, corporate investments are made with cash and return results are measured by cash flow.
‘Whatever Net Income and Shareholders’ Equity are, they are not cash numbers. How can Return on Equity, by any stretch of the imagination, be related to investor return? We have already pointed out investor return is not a function of Net Income, book values, or accounting estimates. Investor return is a function of the net difference between cash invested and cash received from the investment.’
Christy even enlisted Buffett to his cause, arguing that the Oracle from Omaha really only focuses on cash flow, not ROE.
According to Christy, ‘Warren Buffett uses cash flow to value companies he’s interested in buying.’
Earnings, ROE, cash flows, and stock returns
It can all get a bit confusing.
So what does the empirical research have to say about ROE, earnings, and cash flows as predictors of stock performance?
Krishna Palepu summarised some findings on the matter in his Business Analysis and Valuation:
‘Researchers have examined the value of earnings and return on equity (ROE) by comparing stock returns that could be earned by a hypothetical investor who has perfect foresight of firms’ earnings, return on equity (ROE), and cash flows for the following year. To assess the importance of earnings, the hypothetical investor is assumed to buy stocks of firms that have earnings increases for the subsequent year and to sell stocks of firms with subsequent earnings decreases. If this strategy is followed consistently, the hypothetical investor would have earned over a 40-year period an average return of 37.5 percent per year. If a similar investment strategy is followed using ROE, buying stocks with subsequent increases in ROE and selling stocks with ROE decreases, an even higher annual return of 43 percent would be earned. In contrast, cash flow data appear to be considerably less valuable than earnings or ROE information. Annual returns generated from buying stocks with increased subsequent cash flows from operations and selling stocks with cash flow decreases would be only 9 percent. This suggests that next period’s earnings and ROE performance are more relevant information for investors than cash flow performance.’
But the issue gets a bit more nuanced when you disaggregate cash flow.
The 2017 Financial Analysts Journal paper I mentioned earlier analysed the data on free cash flow as a measure of profitability and stock returns.
Here are the conclusions (emphasis added):
‘From an investment perspective, investors may be able to obtain better information about investment prospects—and thus future stock returns—by relying on cash flows that disaggregate operating cash flows from financing, tax, investing, nonoperating, and nonrecurring activities rather than relying on income statement profitability measures. Although “quality investing” strategies based on various fundamental criteria have recently gained notoriety, our study suggests that analysts and investors would be better off following the cash.’
What can we learn from all this?
In my view, investing is more art than science. Therefore, pursuing the one formula or metric that can predict superior returns is futile.
But you can arm yourself with sound principles.
Principles like ‘focus on companies with consistently high ROE’ or ‘follow the cash: free cash flow matters just as much as earnings’.
Financial metrics shouldn’t end your stock analysis but initiate it.
Regards,
Kiryll Prakapenka,
For Money Morning