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Understanding the companyLevel 2Products11 minUpdated Growth, management and capital allocation
Growth, profitability and debt tell you where a company is heading. What management does with the profit tells you who it benefits, and over the long term capital allocation is one of the most important explanations of return.
- Where growth comes from and whether it is sustainable
- What return on capital tells you about quality
- Why debt is leverage in both directions
- How to assess management's capital allocation
Growth: where does it come from?
Revenue growth can come from very different sources, and the source determines how valuable the growth is.
- Organic growth: the company sells more through its own operations. Usually the most valuable, because it tells you about demand.
- Price increases: tell you about pricing power, but only last if customers stay.
- Acquisitions: revenue grows by buying. This can make sense, but it takes money and a successful integration.
- Exchange rates: an international company's revenue in euros can grow without any change in sales volume.
Growth without profitability has no value in itself. If every new euro of sales brings more than a euro of costs with it, growth destroys value instead of creating it.
Profitability: what return does the capital earn?
Margins tell you how much of the sales is left over. Return on capital tells you how efficiently the company uses the money tied up in it, and it is often a more telling measure.
A return on capital that stays high for a long time is one of the strongest signs of a competitive advantage. If a company has done clearly better than average for years, something is protecting it from competition.
Debt is leverage in both directions
Debt isn't automatically a bad thing. It is leverage: if the company earns more on its invested capital than the debt costs, debt improves the owner's return.
The same leverage works in the other direction. When earnings weaken, interest and repayments still have to be paid. An indebted company gets into trouble faster and has less room to maneuver.
- Equity
- 100 million
- Debt
- 0
- Operating profit
- 10 million
- Interest expenses
- 0
- Return on equity
- 10%
- Equity
- 50 million
- Debt (5% interest)
- 50 million
- Operating profit
- 10 million
- Interest expenses
- −2.5 million
- Return on equity
- 15%
In good times, debt raises the return on equity from 10% to 15%. Now see what happens when operating profit halves to 5 million:
- Operating profit
- 5 million
- Interest expenses
- 0
- Return on equity
- 5%
- Operating profit
- 5 million
- Interest expenses
- −2.5 million
- Return on equity
- 5%
The debt-free company still returns 5%. The indebted company returns the same 5%, but half of its operating profit goes on interest, and it has no room to maneuver left at all. If operating profit falls further to 2.5 million, the debt-free company makes a profit and the indebted one breaks even.
This content is for information purposes only and should not be construed as investment advice or a recommendation. Investing always involves the risk of losing capital. The value of financial instruments and investments can go up or down, and past performance is no guarantee of future returns.
Six options for the profit
The right choice depends on the situation. A growing company should usually invest; for a stable, mature company it can make more sense to return money to the owners than to invest it in projects with poor returns.
Dividend or buyback?
Both return money to the owners, but in different ways.
A share buyback only creates value when the shares are bought below their value. If a company buys back its own shares at a high price, it moves value from the owners who stay to those who sell.
How do you assess management's capital allocation?
- Did they deliver what they promised? Compare previous years' guidance and promises with the actual outcome.
- Has the return on capital stayed good after investments and acquisitions? If ROIC keeps falling, the growth has been bought at a high price.
- Is the communication consistent? Does the strategy change every year, and are mistakes admitted?
- What is management's pay tied to? Revenue growth, or return on capital and earnings per share?
- Does management own shares itself? A significant personal holding aligns its interests with the owners'.
This content is for information purposes only and should not be construed as investment advice or a recommendation. Investing always involves the risk of losing capital. The value of financial instruments and investments can go up or down, and past performance is no guarantee of future returns.
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