Generally speaking, the long-term investment returns you tend to get from a company’s shares will bear a reasonably close resemblance to its business performance. Measuring that performance is therefore quite important, but how should the investor go about doing so? I look at some of the ways you can weigh up how well a business is doing and the pros and cons of each approach.
Earnings per share (EPS)
The success or failure of a business usually takes into account its profitability. From a shareholder’s perspective, what better measure of profit could there be than the profit attributable to each individual share which is known as earnings per share or EPS for short.
EPS figures tend to be plastered all over a company’s financial results press releases. It’s a very simple and powerful argument to say that if the profit for each share has gone up then shareholders are better off.
In some cases this will be true, but in many cases it will not be. EPS is one of the most abused and manipulated numbers in finance, which means that investors should be very wary about blindly accepting an increase in it as an indication of the increased well being of the company and their investment in it.
The fact that there are so many different versions of EPS is a good enough reason to mistrust it. Most companies want you to focus on the EPS number that excludes any bad stuff – such as big costs to do with sorting a business out or dealing with loss-making activities – and extra shares that will be issued in the future that will reduce your share of the profits.
If companies have their way, they will try and show an EPS number that moves up nicely year after year. The problem with this is that business life is rarely a smooth upwards path. Bad stuff does happen from time to time, even to the very best businesses.
But this is not the main problem with EPS as a performance measure. The main problem is that it does not take into account how it has been achieved. When you look at any company’s profits you need to understand where they have come from. Great businesses grow profits by growing their revenues and not relying exclusively on cutting costs. They also tend to be very good at growing organically from their existing business.
In a world where borrowing costs are very low, it is very easy to buy EPS growth. This can be done by investing in new assets or buying companies. Even with very low returns on investment, as long as the returns are greater than the after tax cost of borrowed money (interest on borrowings reduces a company’s tax bill) then EPS will increase. The risk is that overpaying to buy companies and making bad investments with borrowed money has a nasty habit of coming back to bite a company and its shareholders at a later date if the profits from them fall.
Profits and therefore EPS can also be manipulated to look better than they really are. Although accounting standards have tightened up a lot over the years, costs can still be shifted away from the income statement. Asset lives can also be extended to lower depreciation expenses and the clever use of provisioning can be used to increase profits.
Perhaps the biggest failing of EPS as a performance in recent years has been the growing use of share buybacks to increase it. If it’s getting hard to grow trading profits then with borrowing costs low and tax deductible why not shrink the number of shares instead.
Last week, I wrote about US coffee giant Starbucks (US:SBUX), which has used share buybacks to juice up its EPS in recent years to great effect, even though profits growth had been slowing down before the Covid-19 lockdowns.
Starbucks: EPS and share buybacks
Non-GAAP et income $m
Non-GAAP diluted EPS $
Change in net income
Change in EPS
Amount Spent $m
Average cost per share $
Sources: Annual reports/Investors Chronicle
Since 2015, the company has spent more than $25bn buying back just over 400m of its own shares at an average cost of around $63 each. As a result, EPS has increased faster than actual profits. Some might say that given the current share price of $75 this has been a profitable thing to do but in reality it is a form of financial engineering.
The company has $25bn less cash and more debt than it previously had and while the financial textbooks and academics will argue that this has created value, I think this is very debatable, but we’ll leave that discussion for another time. Ultimately, increases in company value are driven by permanent increases in profitability and cash flow, not gearing up balance sheets and buying back shares.
Should we be looking at free cash flow instead?
Free cash flow has long been seen as a superior method of measuring a company’s performance, but there are certain limitations of this approach that you need to be aware of.
Companies with poor cash generation should usually be given a wide berth, but just because one seems to be generating lots of free cash flow doesn’t necessarily mean that it is performing well.
Free cash flow has no universally accepted way of calculating it, but it essentially boils down to net cash flow from operating activities less net interest less capex (investment in fixed assets). It is very possible to manipulate free cash flow in the short run by squeezing suppliers by paying them later, collecting debtors faster and cutting back on capital expenditure. These tend not to be long-term generators of value but more one-off changes.
I like to see companies generate plenty of free cash flow and look for high free cash flow margins (free cash flow as a percentage of revenues) of 10-15 per cent or higher, but I also do not want to punish companies for investing in high returning projects that can enhance the long-term cash generating capability of a business.
A great example of a company that has sacrificed free cash flow in the short run for higher cash flows in the long run has been equipment hire specialist Ashtead (AHT).
Ashtead: Free cash flow
Cash generated from operations before rental equipment
Rental equipment bought
Rental equipment sold
Operating cash flow
Interest and tax paid
Exceptional costs paid
Net operating cash flow
Free cash flow
Free cash flow before equipment sales
Sources: Factset/Investors Chronicle
From 2013 until 2016, Ashtead was not producing any free cash flow at all. This was because it was investing its growing profits in more rental equipment. This then generated bigger profits and bigger cash flows which when compared with moderating investment spending later on saw free cash flows increase significantly.
Dismissing Ashtead as a poor investment in 2016 on the basis of its free cash flow would have been a mistake. The key point to have taken on at the time was that it was investing money in new assets that were making very high returns on investment which would bring more profit and cash flow into the business later on.
Return on Capital Employed (ROCE)
ROCE has long been my go-to measure of company financial performance but it too is not perfect.
ROCE is based on profit which has similar issues as discussed with EPS, but it does take into account the amount of money invested to make that profit which EPS (which is after depreciation and interest) arguably does not do well enough.
Operating profit (B)
Capital employed (C)
Operating capital employed (D)
ROCE = B/C
ROOCE = B/D
Capital Turnover = A/C
Source: FactSet/Investors Chronicle
ROCE tells you what the company gets back in operating profit compared with how much money it has invested in the business (capital employed). It is a much better measure than return on equity (ROE), which compares profit attributable to shareholders (or net income) with the money they have invested (shareholders’ equity) as ROE can be distorted by leverage which can increase it even when a company’s profits are not growing.
ROCE is not impacted by how a company is financed and therefore is a much better way of looking at how well a company is doing with all its assets. As a rough rule of thumb, I see a ROCE of 15 per cent or more as a sign of a potentially very good business, but you should also look at the trend as well.
You can split up the ROCE ratio to get some more insight into a company’s performance. ROCE can be calculated by multiplying a company’s operating margin by its capital turnover ratio.
ROCE = Operating profit/Capital employed
ROCE = operating profit/revenues x revenues/capital employed
This allows you to see what is driving ROCE. Is it changes in operating margins or capital turnover? I see capital turnover as a very powerful ratio that is generally underused. It measures how good a company’s investment is at generating revenues. Changes in this ratio can be a good way of spotting turning points in a company’s ROCE. Sometimes, ROCE can be propped up by preserving margins while capital turnover falls. If margins then fall, ROCE can fall sharply.
Capital employed looks at a company’s total invested capital. You should also look at its operating capital which excludes the goodwill paid in previous acquisitions. A company’s ROCE can look very modest because it has paid a lot of goodwill in the past but underneath there can be a very good business when you calculate return on operating capital employed (ROOCE) by deducting goodwill from capital employed.
When a company is investing in new and similar assets to its existing ones in the future, it is the ROOCE that is likely to be a better guide of the money it is likely to make and I would pay more attention to this than ROCE. ROCE which is based on a lot of goodwill can tell you that a company perhaps overpaid for a past acquisition, but if it has bought a good business that it can invest in with high future returns then a low ROCE could cause you to miss out on a potentially good investment.
Ashtead’s ROOCE is a case in point. While its recent results have taken a bit of a hit, you can see that its ROOCE has been consistently high. When this has been combined with high levels of investment (capital expenditure) at the expense of free cash flow it has delivered strong rates of profit growth. Interestingly, its capital turnover ratio has fallen for two consecutive years and this needs to be watched.
ROCE and ROOCE can also give misleading messages from time to time. Companies with heavily depreciated assets can have overstated profits (because depreciation is too low) and understated capital employed (because assets are heavily depreciated) which can give them what seems like an attractive ROCE which will fall – perhaps by a lot – when the assets are replaced.
The new accounting standard on operating leases means that rented buildings and equipment now have to be shown on the balance sheet. I welcome this but investors need to be wary of its pitfalls.
For me, the key issue I have is that it is only the present value of the future committed lease payments that is shown on the balance sheet. This could mean that a company has a very large asset (such as a building) with only one year of its remaining rental agreement to go and therefore just slightly less than the value of one year’s rent shown on its balance sheet (because it is discounted to its present value).
This means that the value of the asset on its balance sheet will bear no resemblance to a comparable asset that is owned outright by a similar company. If the rental agreement is then extended for 20 years then the capital employed of the business will increase significantly in the following year and ROCE will fall.
Cash return on cash capital employed (CROCCE)
An alternative to ROCE which gets round issues such as depreciation which can impact on profits and capital employed is to calculate what is known as the cash return on cash capital employed (CROCCE). This is done by taking EBITDA as the cash profit and adding cumulative depreciation and amortisation to the capital employed figure.
I’ve done the calculation for Ashtead which is shown in the table.
Ashtead: Cash return on cash capital employed
Cash capital employed
as % of Ebitda
As % of cash capital employed
Sources: FactSet/annual reports/Investors Chronicle
Intuitively I can see the appeal of this – comparing cash coming in with cash invested. However, putting aside the view that Ebitda is not the same as cash flow it is a measure I have my doubts about.
First and foremost, I have always believed that a measure of profit used in a return calculation has to be based on what can be paid out to investors (ignoring tax for now). For me, this has to come with some charge for the replacement of assets or stay in business capex. Ebitda fails on this as the money spent on replacement goes into the cash invested and does not reduce profit as depreciation (a proxy for replacement capex) does with operating profit. Ebitda would be fine if the investor accepted that the company was not going to eventually replace its assets which is rarely the case.
CROCCE also flatters companies that are asset intensive with high depreciation expenses. This is one of the reasons why I suspect you see it used by pub companies. For these companies, CROCCE tends to be a bigger number than ROCE as depreciation and amortisation is a bigger proportion of EBITDA than cumulative depreciation and amortisation is of cash capital employed. This is also the case with Ashtead.
That said, I see CROCCE as giving a useful insight to the investor looking at the returns that a company might make over the life of its main assets.