Why I'm Measuring Capital Employed Growth Instead Of Earnings Growth

by: John Kingham

This is the second in a short series of blog posts covering my stock screen and investment strategy updates for 2019 and beyond.

Here’s a list of the other posts so far:

Note: This post covers an update to my Growth Rate metric. If you’re not familiar with it then here’s a link to the original blog post from 2013. And here’s a link to the related and updated Company Analysis Spreadsheet (XLS).

Measuring capital employed growth instead of earnings growth

The first change I made for 2019 and beyond was to switch from using adjusted earnings to reported earnings in all my various metrics.

However, there are downsides to this switch, particularly when it comes to measuring a company’s earnings growth rate. And that’s a problem for me, because my Growth Rate metric is:

Growth Rate = 10-yr. growth rate averaged across revenues, earnings and dividends

It’s a problem because reported earnings are often much more volatile than adjusted earnings, which makes it harder to get a sensible number for reported earnings growth.

For example, imagine a company which has reported annual earnings over a five-year period of £100 million, £200 million, £50 million, £120 million and £80 million. What is that company’s earnings growth rate?

Is it minus 20% over the five years, since earnings dropped from £100 million to £80 million?

Perhaps, but then again, perhaps the £80 million was an unusually poor year and isn’t reflective of what the company could do in a good year.

Using a moving average of earnings is be better, but it can still be heavily impacted if a company reports exceptionally high or low earnings.

That’s why my Growth Rate metric also includes revenue growth and dividend growth; they’re just so much more stable than reported earnings (the volatility of reported earnings is why I originally focused on adjusted earnings).

But now I’m switching from adjusted to reported earnings in all my metrics because adjusted earnings have their own problems.

So, I need to find some other aspect of a company that I can measure, which is more stable than earnings and yet still has a close relationship to the company’s "earnings power", i.e., its ability to generate earnings under normal conditions.

And my chosen replacement is capital employed.

What is capital employed?

Capital employed is the amount of money put into (or retained within) a company from shareholders and debt holders; in other words:

Capital employed = shareholder equity + total borrowings

It’s the raw material with which companies buy factories, machinery, trade marks, stock and other productive assets.

And if a company, say, doubles its capital employed (by investing additional retained earnings and/or debt into productive assets) and is able to maintain its return on capital employed, then it will double its earnings.

So, a company’s potential earnings are closely related to its capital employed, and yet, on a year-to-year basis, capital employed is extremely stable, at least most of the time. And that makes measuring its growth rate relatively easy.

I wrote about this before Christmas, where I said I would be measuring tangible capital employed growth, but upon further reflection I’ve now changed my mind. Instead, I’ll be focusing on capital employed including intangibles.

There are sound arguments on either side of the tangible/intangible debate, but I’ve decided to go with the default version of capital employed because:

  1. It’s easier to calculate; and
  2. I want to see a decent rate of return on all the capital employed within the business, including goodwill, trademarks, patents, computer software or any other intangible assets.

So my updated Growth Rate metric is now:

Growth Rate = 10-yr growth rate averaged across revenues, capital employed and dividends

As an example, here’s a chart for Ted Baker (which is a holding in my model portfolio) showing the growth of its revenues, capital employed and dividends:

For most companies, capital employed growth is necessary to drive earnings growth

Measuring total asset growth for Banks and insurers

The old Growth Rate metric for banks and insurers was slightly different because their operating model is different. Instead of measuring revenue, adjusted earnings and dividend growth, the old financial company Growth Rate measured net asset growth, adjusted earnings growth and dividend growth.

The reason is that financial companies don’t have "revenues" as such, so I chose net assets (shareholder equity) instead.

Now that adjusted earnings are being replaced with capital employed in the standard Growth Rate metric, I can’t do the same for the financial company version. That’s because financial companies don’t usually have much in the way of operational borrowings, so their capital employed (shareholder equity plus total borrowings) is very similar to their net assets (shareholder equity).

So, instead of replacing adjusted earnings with capital employed, for banks and insurers I’ll be replacing them with total assets (more accurately, net assets are used instead of capital employed, and total assets are used instead of revenues).

For banks and insurers, total assets are closely related to the company’s "earnings power" because their assets are the vehicle through which they generate earnings:

  • For banks, total assets are mostly loans, on which customers have to pay interest (and more loans equals more interest, more or less)
  • For insurers, total assets are mostly pooled insurance premiums, which generate two income streams:
    • Underwriting profit: A small percentage of pooled premiums will hopefully turn into profits if the company has priced its insurance policies effectively.
    • Investment profit: The pooled premiums are invested, and those investments produce profit in the form of investment returns.

As well as being closely related to a company’s earnings power, total assets are also very stable year to year, especially when compared to reported earnings. And that makes measuring total asset growth relatively easy.

The next post in this series will look at changes to my Profitability metric.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.