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What is the most important ratio for an investor? Most value investors would answer this question with the price-to-earnings ratio (P/E ratio), the price-to-book ratio (P/B ratio), the PEG ratio, the Return on Equity or some other important metric showing either how inexpensive a stock is or the quality of the company. I would answer that the most important metric for any investor is this:

Whether a fundamental or technical investor, a long or short term investor, a bottom up or top down investor this is the fundamental determinant of your success. A technical investor need not go any further but fundamental investors need to look for things such as the P/E ratio or P/B ratio, which have a high correlation with greater long-term returns. I think it is possible to break down the statement above in a way that shows a deterministic method for showing where past returns have come from and predicting what future returns will be. The first step of this process is the statement below:

Although the statement on the right may look confusing at first it actually is the same as the statement on the left, with each of the other values canceling with each other and leaving us with only the future price over the current price. This can actually be simplified a bit further, into common terms, as shown below:

As shown above, any future capital gains are the result of:

  • Book Value Growth
  • ROE Growth
  • And an expanding P/E Multiple

These terms are known by value investors everywhere and are often associated with higher returns, but when they are combined they can actually show why you have received those higher returns. It is worth looking at each term further to determine what to look for and to see some qualitative factors affecting these returns.

An Expanding P/E Multiple

Since an investor has no control as to what P/E multiple a stock trades at in the future, the easiest way to gain from this factor is to buy stocks at a low price. This is far from a revolutionary idea and multiple studies have been written correlating low P/E ratios with higher returns. It also suggests looking to sell at a fair or relatively high P/E ratio as part of your exit strategy. Low P/E stocks have a tendency to include value traps, however. Combining the 2 other factors does a good job of filtering out that type of stock.

Book Value Growth

Book value growth has a number of qualitative factors which must be taken into consideration; quality growth is far better than a company that is growing recklessly. If book value growth leads to a lower return on equity (Earnings/Book Value), because of a fruitless acquisition, a company growing its cash hoard, or a company growing in a less profitable segment, it may as well be running on a treadmill: it'll expend a lot of effort but go nowhere. A company which maintains a high return on equity also has an easier time growing its book value, as the firm's high returns will give them the necessary capital to fund its faster growth.

Estimating future book value growth is relatively easier for a highly scalable business such as a restaurant, a retailer, REITs, banks or other companies which produce a fairly fixed return on a given type of asset (such as a building, inventories, receivables or capital). Although it is more difficult to estimate for other companies it is still possible to get in the right ballpark by looking at future capex and working capital needs.

Another point worth mentioning here is that a company with a prudent capital allocation strategy will have a better chance of performing well on each of these factors. This method measures growth in market cap, meaning dividends and buybacks don't factor into the equation, but companies such as the dividend aristocrats often perform well on these measurements. A company with an appropriate dividend and buyback program, a policy which doesn't hinder growth and uses the cash which would otherwise fund lower ROI investments, has a much better chance of succeeding than a company trying to build an empire or one which holds unnecessary cash on its balance sheet.

Return on Equity Growth

A high and growing return on equity is usually indicative of a competitive advantage and the growth of ROE usually indicates that the company has a widening economic moat (an advantage which keeps competitors at bay). I believe this factor is one of the most important determinants for overall return, yet the most missed by the average investor. If a company has a temporarily high ROE due to a short term benefit but no long term competitive advantage it could easily become a value trap, even if purchased at a low P/E ratio and despite any growth it may have. Another factor which is often missed is goodwill: a company which has completed a large acquisition but has significant organic growth opportunities in the future may be able to grow its return on equity by simply maintaining its return on tangible equity (a term giving you the return on actual physical assets, which excludes goodwill and intangible assets).

Another way to break down ROE growth is using the DuPont formula, shown below:

ROE growth can either be a result of added financial leverage (assets/equity), increased operating efficiency (revenue/assets), or improved profit margin (earnings/revenue).

  • An underleveraged company adding a reasonable amount of debt or a company which is able to leverage its supplier or distributor relationships to increase payables and reduce receivables can improve its financial leverage (assets/equity).
  • Increased same store sales or greater capacity utilization increase a company's operating efficiency (revenue/assets).
  • Increased gross margin or a more efficient cost structure will improve a company's profit margin (earnings/revenue).

Combining these two equations gives you the following equation which can be used on its own or combined with those above:

An example:

McDonalds (MCD) performance from 2000 through 2011 has been rather impressive.

(Click to enlarge)

Despite negative results through 2002 which cut the stock price in half the company more than doubled its market cap during this 11 year period, a time when the market as a whole went nowhere. The relevant numbers which brought these results are below:

2000 2011 Growth
Book Value $9,204 $14,390 56.35%
P/E Ratio 22.82 19.04 -16.57%
ROE 21.48% 38.24% 78.04%
A/E 2.36 2.29 -2.69%
Rev/Asset 0.66 0.82 24.63%
Net Margin 13.88% 20.38% 46.80%
Market Cap $44,367 $103,551 133.40%

McDonald's experienced strong returns because of its strong ROE and book value growth, slightly offset by a lower valuation (this was end of year 2000 through the end of year 2011). ROE grew through greater operating efficiency and net margin both due to strong same store sales and an increased franchising percentage.

Ratio of 2011 to 2000
Book Value 156.35%
P/E Ratio 83.43%
ROE 178.04%
Market Cap (Predicted) 232.23%
Market Cap (Actual) 233.40%

The result given by the equation nearly matched the actual results, with the slight error likely caused by dilution and rounding errors.

Source: A New Method For Calculating Fundamental Returns