In an age, where scaling up and growth seems to have won out over building business models and profitability, as the most desirable business traits, it is worth stating the obvious. The measure of a good business is its capacity to generate not just profits, but also to convert these profits into cash flows that investors can collect. If we needed a reminder of this age-old premise, the last three weeks should have provided a wake-up call. In fact, if your central concern is about the negative economic consequences of the viral meltdown, in the short and the long term, higher growth and margin companies will be best suited to not just survive them, but emerge stronger in the post-virus economy. In this post, I will try to look at growth, earnings and cash flows, and how they interact in value, and use that framework to examine how companies around the world, in different sectors, measure up.
Growth, Profits and Cash Flows
The trickiest part of valuation is negotiating a balance between growth, profitability and reinvestment, with a plausible story holding them together, to derive value.
- The Scaling Factor: Growth plays the 'good guy' role, allowing small companies to become big, and big firms to become even bigger. While a growth rate can be computed on any metric, the metric that best reflects operating growth is revenue growth, accomplished by either selling more units or raising prices.
- The Profitability Driver: Growth, by itself, can only scale up a firm's operations and revenues, but for that scaling up to pay off, it has to become profitable. Again, while there are many measures of profitability, scaling profits to revenues to arrive at profit margins makes the most sense.
- The Reinvestment Lever: To grow, a company has to reinvest in capacity, in whatever form, and this reinvestment can drain cash flows. This reinvestment can be tied to earnings, as a retention ratio or a reinvestment rate, or to sales, as a sales to invested capital ratio.
If that sounds familiar, it is perhaps because you have seen me value many companies on this blog, using these three variables, added on to a risk component, to value companies as diverse as Kraft Heinz to Tesla to Beyond Meat. In fact, the cash flows that you observe for a firm can be captured by the interactions between these three forces, and those interactions let us differentiate between great, average and bad firms:
The extremes represent the best and worst possible combinations of these variables. Great firms pull off the trifecta, scaling up revenues with relatively little reinvestment, while deliver high margins. Terrible firms are saddled with the worst possible mix of low revenue growth, low or even negative margins and large capital investment requirements to deliver even their growth. The bulk of the business world falls in the middle, facing tradeoffs that determine value. Some trade off low margins for high growth, hoping that the dollar profits they deliver will be large enough, simply because of scale. Others are willing to reinvest more in the short term, to build barriers to entry and generate higher and more sustainable margins and returns for the long term. In the rest of this post, I plan to look at how companies around the world measure up on each of these dimensions, beginning with the growth that they have recorded in the recent past, moving on to measures of profitability and ending with reinvestment numbers. I will then close by bringing in the hurdle rates that I estimated in my last post as benchmarks, to measure how firms measure up on value creation or destruction.
Growth
The first variable that I will look at is growth, and focus primarily on past growth in different metrics, ranging from revenues (the top line) to net income (the bottom line). Along the way, I will argue that the way growth rates are estimated and the periods used for the estimation can have large effects on the numbers that emerge, and that bias, as with everything else in valuation, can affect choices.
Growth Metrics
Investors often make the mistake of assuming that, since the past is behind the, a historical growth rate for a company is a fact, not an estimate. That is a myth, since the historical growth rate that is reported for a company is a function of multiple choices made on estimation, as can be seen in the picture below:
So what? First, it is worth remembering that that the biases an investor brings to the table will often determine how, and in what metric, growth is computed. In general, at least in good times, earnings per share growth will be the mantra of bullish investors in a stock, whereas top line growth will the number offered by more pessimistic about the stock. Second, if you are using growth rates for companies from a data service, it is always worth asking questions about the approach used to compute growth (arithmetic or compounded) and time period used (starting and ending years), since they can skew growth rates up or down.
Growth Rates - A Global Overview
In keeping with the theme that with growth rates, it behooves us to be transparent about estimation choices, I will start by explaining my choices when it comes to growth. For historical growth rates, computed at the start of 2020, I use the compounded average growth rate in the previous five financial years. For most firms in my sample, this is the geometric average growth rate from 2014, as the base year, to 2019, as the final year in the sample. I will also compute growth rates in revenues (top line) and net income (the proverbial bottom line). With the latter, there will no growth rates computed for companies that are money losing, since the growth rate becomes a meaningless number. With that lead-in, I start by estimating growth rates by industry group, and in the table below, I list the ten industries with the highest growth rate in revenues in the last 5 years (2014-19) and the ten with the lowest:
Note that even before the crisis, oil companies were shrinking, computers/peripherals had close to flat sales, and software dominates the list of high growth businesses. For a full list of growth rates, by industry, please click here. To see if there are differences in growth in different parts of the world, I then break down growth rates in revenues and net income, by region, between 2014 and 2019.
Note that more than a quarter of all publicly traded firms saw revenues shrink, in US dollar terms, over the last five years, and that across all firms, the median growth rate in net income is much higher than the median growth rate in revenues, across all regions. However, the range on net income growth is wider than the range on revenue growth. Finally, it is worth noting that investing is based upon future growth, not past growth, and I use estimates of expected growth rate in earnings per share as my proxy. Notwithstanding the biases that analysts bring into this estimation process, it remains a forward-looking number, and I look at how expected growth in earnings per share varies across companies in different PE ratio classes:
While this data is too raw to draw big conclusions from, higher PE stocks have, not surprisingly, have higher expected growth rates than low PE stocks. As investors, though, that tells you little about whether high PE stocks are good, bad or neutral investments, since the enduring question becomes whether (a) the high expected growth reflects reality or hopeful thinking on the part of analysts and (b) the PE ratio fully, under or over reflects this expected growth rate. It is one reason that I remain wary of using pricing screens to pick stocks, since there is no short cut or formula, that will answer this question. That will require a deep dive into the company's business model and full forecasting of earnings, cash flows and risk, i.e., an intrinsic valuation.
Profitability
Growth is only one part of the valuation puzzle, since without profits that come with it, it will be wasted. In this section, I will look at profitability across regions, sectors and subsets of stocks, again with the intent of eking out lessons that I can to in corporate finance, investing and valuation.
Margin Definitions & Usage
With profit margins, you scale profits to revenues, and as with growth, there are multiple metrics that can be used to compute margins, and which one is used is often a reflection of the biases that investors bring to the game. In the picture below, I look at a list of possible profit margins, and what each one is trying to measure:
By itself, each margin serves a purpose and tells a tale, and is worth calculating. Thus, the contribution margin measures the pure profits that you generate with every marginal unit you sell, since it nets out only the variable cost associated with producing that unit, giving many software companies close to 100% contribution margins. Gross margins are a close relative, providing a direct measure of marginal profitability and an indirect measure of how revenue increases flow into profits. To illustrate, Zoom, one of the few stocks that has seen its value increase during the crisis, reported a gross margin of 92% in 2019. Operating margins measure what is left after the other operating expenses of the company, which cannot be directly traced to individual unit sales, but are nevertheless necessary for its operations. Thus, R&D expenses and SG&A costs are netted out from gross profit to get to operating profit, yielding a measure that will capture economies of scale, as the company scales up. Netting out taxes and interest expenses, and adding back income from cash and cross holdings, yields net margin, a measure of what equity investors get to keep out of every dollar of revenues. It is a mixed and noisy measure, reflecting a company's operating model, its tax liabilities and its financial leverage (since debt creates interest expenses and affects taxes), as well as non-operating assets. Along the way, there are diversions. If you take the operating income, act like you have no debt and net the taxes you would have paid on that operating income, you get after-tax operating margin, a measure of operating profitability that takes into account taxes. If you take operating income, and add back depreciation and amortization, you get EBITDA margin, a measure of operating cash flows, before reinvestment. In recent year, companies with large stock based employee compensation have taken the tack that since it is in the form of shares or options, it is not an expense, and have added back this and other "extraordinary" expenses (with lots of leeway on what comprises extraordinary) to compute adjusted EBITDA margins that supposedly capture even better the cash flows at the firm.
As you look at margins, whether reported by a company or computed by a third party (including me), here are some general principles to keep in mind. First, desperation drives a money-losing company up the income statement to use more expansive forms of margin. Notice that Microsoft, which has operating margins of close to 35% and net margins of 20% plus, never talks about gross margins, whereas some of Tesla's biggest promoters keep bring up the fact that its gross margin is 25%. Boasting that your gross margin is positive is akin to being on a diet and claiming that you consume only 1800 calories a day, but that is before you count the calories in the second courses at meals, desserts and snacks. Second, not all adjustments are created equal. I have long argued that while adding back depreciation and amortization to get to an EBITDA margin may be justifiable, adding back stock based compensation is not, since it is effectively using a barter system to evade cash flows. Put differently, you could have issued those restricted shares or options in the market, and used the cash to pay your employees, and chose not to.
Margins: A Global Overview
As with growth rates, I am going to begin by offering some background on the data that I use to compute my margins, and the adjustments that I make along the way. I use the revenues and income numbers from the trailing 12 months, which at the start of 2020, would give me the financials for most firms from October 2018 to September 2019. While that may seem short sighted, I have the
archived numbers from the last decade on my website, for you to download and make your own judgments. Of course, with the market crisis fully upon us and a recession looming, you will be well served looking at the historical data. I start looking at margins across industries, to get a rough measure of how revenues flow through as earnings to the firm and its equity investors. In the table below, I list the ten industry groups with the highest and lowest operating margins, using global companies:
Note that retail is particularly exposed in this crisis, simply because margins were low to begin with, though the question of how much will vary across retail. Thus, grocery and online retail may be more resilient than automotive and general retail from a prolonged shut down of commerce. Among the highest margin businesses, there are many that will see margins deteriorate very quickly from this crisis, with energy (both oil and green) showing the biggest near term hits. Real estate will also be exposed if there is a deep recession, but software, beverages and tobacco should see profitability hold up better. Looking across regions, I compute profitability measures across all companies in each region, recognizing that the industries that dominate each region be very different.
Note that the Asia had the lowest margins in 2019, a warning that high growth does not always translate into profitability. Conversely, Eastern European & Russian companies have high margins, albeit with low growth. African and Middle Eastern companies have sky high margins, reflecting domestic companies that dominate local markets with little competition.
Reinvestment Efficiency
If revenue growth captures the scaling up factor, and margins the profitability of a business, the last part of the story has to be about the efficiency with which the growth is delivered. For manufacturing companies, this will be captured in how much they spend in adding production capacity, and how efficiently they use this added capacity to produce more units. For non-manufacturing companies, the investment may be in research and development, acquisitions and other "intangibles", but it too is reinvestment and its payoff in growth affects value. For retail firms, it may take the form of inventory, accounts receivable and other ingredients of working capital, and how well they can manage these as they grow.
Reinvestment Efficiency: Definitions & Usage
Unlike revenue growth and margins, which has widely accepted proxies and measures, reinvestment efficiency remains more of a smorgasbord of different measures. Broadly speaking, these measures scale how much capital is invested either to the operating income that is created, in returns on capital measures, or to revenues, by relating capital invested to revenue growth.
In sum, reinvestment in any period is defined broadly to include not just investments in plant and capacity, the accountant's traditional cap ex measure, but also working capital, acquisitions and investments in research and development and intangible assets.
Reinvestment = (Cap Ex - Depreciation & Amortization) + Change in non-cash Working Capital + Acquisitions + (R&D expenses - Amortization of R&D)
That reinvestment accumulated over time comprises the invested capital of the firm, and both numbers (reinvestment and invested capital) can be scaled to either after-tax operating income or to revenues. When margins are stable, the two approaches are equivalent, but when the margins are changing, the revenue-scaled measures become more useful.
Reinvestment Measures: A Global Overview
I noted at the start of this post that "ease of scaling up" has become a central theme of young growth companies reaching into new and often very large markets. While this has always been a selling point for conventional software and technology firms, it has expanded its reach into other businesses, from Uber in car service/logistics to Casper in mattress sales. In essence, the selling point for these models is that they can reinvest much more efficiently than their established competitors, though their growth pitch is still more focused on sales than on profits. In this section, I report on investment efficiency numbers, staying true to my premise that reinvestment has to include acquisitions and R&D. To get a sense of how investment efficiency varies across industries, I computed sales to invested capital and returns on capital, across industry groups, and in the table below, I report on the ten most and ten least efficient industries, at least when it comes to delivering revenues for every dollar of capital invested.
Looking at regional differences, again recognizing that the industry concentrations vary geographically, I find the following:
Note that the concentration of natural resource companies in Australia, New Zealand and Canada, which lowered profitability, is also showing up as lower returns on capital. The more troubling number is the 4.55% median return on capital delivered by the median global company in 2019, not only well below the cost of capital globally, but also likely to see a major hit this year, as the Corona Virus works through the global economy.
Excess Returns
I talked about risk and hurdle rates in my four earlier data posts, where I started with the price of risk in markets (equity risk premiums and default spreads) and then about relative risk measures. In this last section, I will bring together the return measures discussed in the last section with the hurdle rates estimated in prior posts to create composite measures of excess returns, as measures of value creation.
Excess Returns Definitions and Usage
While businesses that make money are viewed as successful, that is a low hurdle for success. After all, capital is invested in businesses and that capital invested elsewhere, in equivalent risk investments, could have earned a return. That return is what we were trying to estimate, with all of its complications, in my previous updates on risk free rates, equity risk premiums and relative risk measures.
These comparisons, which are at first sight simple, are complicated by how well we can measure how much capital is invested in a project or existing assets and how closely the accounting earnings capture true earnings. Adding to the measurement issues is the fact that earnings are volatile and using a single year's number can skew our conclusions.
Excess Returns: A Global Overview
With the caveat in mind that the returns on capital that I compute for individual companies reflects operating income in 2019, a potential problem given that it is just one year and a number that clearly will change (and fairly dramatically so) because of the virus, I compared the return on capital to the cost of capital for each of the 39,000 non-financial service companies in my sample and used that comparison to create a global distribution of excess returns:
The story here is a depressing one, at least for this comparison, as 54% of global companies generated returns on capital that were lower than their costs of capital by 2% or more, and 32% of global companies earned returns that exceeded their costs of capital by 2% or more; 14% of companies earned returns that were within 2% of their costs of capital. The only part of the world where more companies earned more than their cost of capital than earned less was Japan, and even there, there are questions about whether this is an artifact of Japanese accounting practices rather than a sign of value creation. To complete the assessment, I looked at excess returns generated, by industry, and created a listing of the five industry groups with the most positive and the five with most negative median excess returns:
You may be surprised to see biotechnology and healthcare IT at the top of the list of negative excess return businesses, but given that many of the companies in these industries are still young, money-losing firms with promising products in the pipeline, this may be more a reflection of the limitations of using return on capital with young companies, than a true measure of excess returns. The presence of mining and oil/gas on the list is more troubling, since it suggests that even before the brutal shocks meted out in markets in the last few weeks, these sectors were struggling. It should be no surprise that the businesses that have the highest excess returns are mostly service companies, with low capital intensity, with the exception of tobacco, a high-margin business that also has the benefit of providing a non-discretionary product.
Wrapping up
Heading into a post-virus economy, where there will be wrenching changes in most sectors, you may wonder why I even bother looking at the profitability and excess returns from 2019. After all, every one of the numbers reported in this post will be dated, as companies update their financials to reflect the damage done. That said, I think it still makes sense to look at growth, profitability and reinvesting, pre-crisis, to get a sense of how much punishment companies can take. In businesses that already had anemic revenue growth, low margins and poor investment efficiency, the effects of the crisis will be far more devastating than in businesses with higher growth, margins and efficient investment. There is a reason why airlines, retail and oil are in the front lines of this war, suffering the most casualties, and why technology and heath care are doing better.
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Growth, Profit Margins, Reinvestment Efficiency and Excess Returns, by Region: 2020
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Growth, Profit Margins, Reinvestment Efficiency and Excess Returns, by Industry: 2020
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