Money, not margins

Why then do so many in the City focus - almost to the point of obsession - on these various rates of return? An acceptable answer would be because one sort of margin - return on capital - matters very much if it fails to meet a minimum level (more of that in a moment), although profit margins matter not a jot. Yet that qualification rarely enters analysts' thought processes. Instead, they are seduced by what is superficially investment-orientated (margins, or rates of return) and reject what seems appallingly unsophisticated (money).

In this context, there was some flawed commentary on the rather miserable 2013-14 results from supermarkets operator Wm Morrison (MRW). The well-publicised backdrop is that the Bradford-based retailer is a shadow of its former self as its chief executive, Dalton Philips, tries every known innovation to brush up performance. But failed initiatives meant £903m of exceptional costs in 2013-14 and £176m of pre-tax losses. This year the results may be even worse as Morrison's latest wheeze is once again to be a price leader; at least its bosses say that price promotions mean that underlying pre-tax profits may be little more than a third of the level of the year before last.

Analysts assume - probably correctly - that Morrison's price promotions will erode profit margins even if the extra sales, propelled by keener prices, drive up cash profits. In turn, that will affect the all-important return on capital employed (RoCE). According to one piece of analysis, Morrison made an 11 per cent RoCE last year, but would make just 9.4 per cent this year, given some assumptions about sales growth and lower profit margins. And because Morrison's RoCE would shrink, then its experiment with keener prices would have failed, ran the argument.

Well, not quite. True, if that 1.6 percentage point gap in RoCE before and after the price cuts persisted, then the experiment would have failed. But the test is not the level of return on capital per se. Rather, it is the money profits that can be generated given various levels of capital that can be employed in the business and the cost and returns thereon.

Take the table, which illustrates a simplified example using figures not a million miles away from what could apply to Morrison. Before the price promotion, this Morrison look-alike employed £5,000m of capital (we are not bothering to distinguish between debt and equity, though in the real world that would be relevant). On that it generated £550m of operating profit net of tax for an 11 per cent return. Like everything, however, capital has a cost, which we assume to be 8.5 per cent (in the real world the blend of tax-deductible debt and comparatively expensive equity would be a big factor). That is £425m of cost, leaving £125m of 'residual' profits. True, money profits could be even more than that because much of the cost of equity is an 'opportunity cost' (ie, the return that an investor would expect in order to justify whatever he paid for the shares). But this opportunity cost is real enough - the market makes sure of that. And if a company is not making residual profits after its full cost of capital - both cash cost and opportunity cost - it's not making 'real' profits at all.

Next, assume that after the price promotion the Morrison look-alike finds that, although squeezed profit margins drive down its return on capital to 10.5 per cent, the experiment was sufficiently successful for management to employ much more capital in the group. Hence, capital employed rises by a third to £6,500m and, meanwhile, the cost of capital stays the same. As a result, there is more net operating profit, a higher cost of capital, but - crucially - more money profits and more 'residual' profit.

Putting a cost on capital

True, there is a margin at the bottom of the calculation - that of profit to capital employed. If that remains poor - certainly below a company's cost of capital - then no amount of tinkering will make a good company or a successful investment. But, so long as the return on capital exceeds its cost, then money matters more than margins.

Not that this necessarily feeds through to a recommendation on Morrison's shares. That said, as far as one can calculate it, even in 2013-14 Morrison made both a return on capital and on its equity component that exceeded their respective costs (though the cost of equity is largely a subjective figure). That may not be in the share price - 208p - which implies that the market reckons Mr Philips's plans are doomed. Given his four-year record at Morrison, that's understandable. Yet, if - big if - Morrison shows signs of decent trading as the year progresses, the share price has the scope to rebound strongly.