It is common knowledge that Wall Street is obsessed with the bottom line. Investors closely monitor earnings announcements to gauge a company’s performance. Stock prices can jump on positive earnings surprises and conversely nosedive when earnings expectations are missed even by a few cents.
We don’t deny that profits do provide a measure for a company’s long-term growth and staying power. Moreover, long-term investors buy shares on the anticipation that the company will generate a growing stream of cash or earnings in the future. But are “higher” profits necessarily better? Are they really a true indicator of the staying power of a company’s earnings?
Making Sense of Profits
Generically, there are three ways to measure profitability, and all of them come with caveats:
- Dollar Profits: For sheer shock value, dollar profits trump all other measures hands down. Most of us are unused to thinking in millions of dollars, and such numbers seem striking and awe-inspiring at a first glance. But, higher profits do not necessarily indicate true profitability, as they are absolute numbers. They do not relate profits to the size of the company, its sales, its resources or shareholder capital.
- Profit Margins: A better way might be to scale profits to total revenues, as in Net Profit Margin (Net Profit/Total Sales). However, there is a fundamental problem with this ratio, as it involves a trade-off between margins and turnover. In other words, a company can sell lower quantities at higher prices (and thus high margins) or go for lower prices and higher quantity. In the retail industry, for instance, we can see both strategies at play. Wal-Mart Stores Inc. WMT has low margins but huge turnover, and thus ends up making enormous profits. On the other hand, most luxury retailers have much higher margins than Walmart but struggle to report even scanty profits.
- Returns on Investment: The only profitability measure that reasonably works across industries is the ratio of return generated on the dollars invested in a business. The most popular among these ratios is Return on Equity (“ROE”), favoredby both Wall Street analysts and investors alike. There is another, lesser-known metric — Return on Invested Capital (ROI) — that we will shed light on today.
Is ROE Really Creditable?
It is a tricky task for investors to break through management’s feel good, “it’s all great if you ignore the bad stuff” earnings metrics and get a sense of a company’s true profitability. Since the ROE measure receives the most attention from the investor community, executives focus heavily on this metric as well.
However, management can artificially boost ROE by piling on debt. Higher leverage makes the company riskier, not better. Companies can exploit financial strategies (like increasing debt leverage and stock buybacks funded through built up cash) to artificially maintain a healthy ROE for a while, and conceal weakening operational profitability.
However, excessive debt leverage becomes a major albatross for a company when the demand for its products heads south. During tough times, it multiplies a company’s risk manifold.
So, let’s shift our focus to a different bottom-line metric that garners far less attention from executives and investors alike, Return on Invested Capital (“ROI”).
The Lesser Known Metric: ROI
ROI is computed as net income from continuing operations divided by (debt + equity) and it measures the company’s ability to generate profit from all sources of funds including those which arise from liabilities to creditors (debt) as well as those from contributions by investors (equity). ROI circumvents the potential distortions created by financial strategies like those we just discussed.
If we really think about it, the most crucial job of a company’s management’s is to allocate its resources prudently. Anybody can make a profit by throwing a stack of money at a problem, but there are very few managers who have the talent to generate large profits with little investment.
Essentially, ROI shows how optimally management is directing the capital under its control into profitable investments. It paints a clear picture of how efficiently a company is employing its capital, and whether its competitive positioning is allowing it to produce good returns from that capital.
ROI is particularly relevant for assessing companies that have a large amount of capital.
Our Screen
However, it might be quite difficult for investors to single out such companies, as we need companies which have generated strong ROIs over a sufficiently long period of time to determine a strong trend.
So, we created a three faceted screen to shortlist such companies for you. Only those companies which have generated ROIs in excess of 15% on average over the last 5 years can get past our screen. Their current ROI (over the trailing twelve months) also needs to be at least 15%.
In addition, to ensure that we hone in on stable companies which have an established history of generating profits, our screen allows only those companies which have a market capitalization north of $10 billion.
Needless to say, these companies must have a solid Zacks Rank too. A favorable Zacks Rank shows positive analyst interest and great prospects for the company.
Just five companies got through our screen, and here they are:
Accenture plc ACN
Accenture provides management consulting, technology, and outsourcing services globally.
The outsourcing giant has generated an incredible average ROI of 52.2% over the last five years, and boasts a current ROI of 50.3%.
Over the past month, analysts have become increasingly bullish on the Zacks Rank #2 (Buy) stock. The company has seen a sharp spike in the Zacks Consensus Estimate for 2016, which now stands at $5.28, up from $5.21 a month back.
Broadcom Limited AVGO
Broadcom is a premier designer, developer and global supplier of a broad range of analog semiconductor devices and digital, mixed-signal and optoelectronics components and subsystems.
This Zacks Rank #2 stock has generated an impressive ROI of 27.9% on an average over the last 5 years, and has a current ROI of 28.9%.
Analysts envision a healthy future for the company, as the Zacks Consensus Estimate for 2016 earnings has trended sharply up over the past month, from $8.92 to $9.26 per share, thanks to five upward estimate revisions.
Gilead Sciences Inc. GILD
Based in Foster City, CA, Gilead Sciences focuses on the discovery, development and commercialization of drugs for several indications.
This Zacks Rank #2 stock has generated an average ROI of 33.1% over the last 5 years, and its current ROI stands at 53.9%.
Analysts have great expectations from the company this year and have been revising 2016 earnings estimates upward over the past month. Gilead’s fiscal 2016 estimate has climbed from $11.96 to $12.11 over the past 30 days.
ULTA Salon, Cosmetics & Fragrance, Inc. ULTA
UltaSalon operates as a specialty retailer in the United States. The company’s stores provide cosmetics, fragrance, haircare, skincare, bath and body products, and salon styling tools.
This Bolingbrook, IL-based beauty retailer’s earnings has generated an average ROI of 23.1% over the last 5 years, and boasts a current ROI of 23.9%.
Moreover, analysts have become increasingly bullish on this Zacks Rank #1 (Strong Buy) stock over the past month, with 13 upward estimate revisions for the company’s 2017 earnings. This has led to a sharp spike in the Zacks Consensus Estimate for 2017, which now stands at $5.94, up from $5.68 a month ago.
NetEase, Inc. NTES
This internet technology company is primarily engaged in the development of online games, e-commerce and related technologies in China.
This Zacks Rank #1 stock has generated an average ROI of 24.5% over the last 5 years, with a current ROI of 25.1%.
Over the past month, analysts have become increasingly bullish on the company, with two upward estimate revisions for the company’s 2016 earnings. This has led to a sharp spike in the Zacks Consensus Estimate for 2016, which has increased from $8.44 a month ago to $9.46 today.
Look Beyond the Obvious
These stocks have proven their mettle consistently during challenging times, and look set to outperform their peers simply by efficient usage of their assets.
So, let’s play a different game this time. Let’s drown out the sound of earnings beats and misses and focus on true, sustainable profits that look beyond just the next quarterly set of numbers.
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