Measure returns, not just growth

A company can grow sales without improving the value of the business. It may need so much additional capital to produce each dollar of growth that the benefit to owners is limited.

Return on equity

Return on equity (ROE) = Net profit ÷ Average shareholders’ equity × 100

Suppose a company earns $1 million on average equity of $5 million. Its ROE is 20%. That seems encouraging, but ROE does not explain how much risk the company assumed to produce the result.

Imagine the company borrows heavily and uses the money to repurchase shares. Its accounting equity may shrink, causing ROE to increase even if operating performance stays unchanged. This is why high ROE must be investigated alongside leverage.

Figure 1How a debt-funded buyback can lift ROE without better operations

	Before	After buyback (illustrative)
Net profit	$1.0m	About $1.0m, before extra interest
Average equity	$5.0m	Smaller
ROE	20%	Higher
Debt and risk	Lower	Higher

Return on invested capital

Return on invested capital (ROIC) tries to compare operating profit after tax with capital supplied for operating purposes. Different analysts use different adjustments and definitions, so comparisons need consistent methods.

Its broader lesson is straightforward: What economic profit does the business earn from the capital it requires?

Earnings per share and buybacks

Earnings per share (EPS) measures earnings attributable to each share. If total profit remains unchanged while the number of shares declines, EPS may rise because each remaining share represents a larger ownership fraction.

Buybacks can be beneficial when shares are purchased at sensible prices without harming financial flexibility. They can destroy value when funded imprudently or made at excessive valuations. Always review share counts, buyback prices and debt levels together.

Growth deserves a return test

Suppose a proposed project requires $4 million of new capital and is expected to generate $200,000 in additional annual operating profit after tax. That is a 5% illustrative return on incremental capital. Whether it creates value depends on project risk and the company’s cost of capital.

Figure 2Growth deserves a return test

Return on incremental capital = Extra operating profit after tax ÷ New capital

1. $200,000 ÷ $4,000,000 = 5%
2. Compare 5% with the cost and risk of the capital required

Growth that consumes capital at poor returns can make a business bigger without making it better.

Break return on equity into its parts

Return on equity can be split into three parts, which shows where a high or low figure comes from:

ROE = Net margin × Asset turnover × Financial leverage

where net margin is net profit ÷ revenue, asset turnover is revenue ÷ total assets, and financial leverage is total assets ÷ equity.

Using the example company, suppose it earns $1 million on revenue of $10 million, holds total assets of $12.5 million and has equity of $5 million. Then:

• Net margin = 1 ÷ 10 = 10%
• Asset turnover = 10 ÷ 12.5 = 0.8
• Financial leverage = 12.5 ÷ 5 = 2.5
• ROE = 10% × 0.8 × 2.5 = 20%

Figure 3Three routes to the same 20% return on equity

ROE = Net margin × Asset turnover × Financial leverage

Net margin

net profit ÷ revenue = 10%

Asset turnover

revenue ÷ total assets = 0.8

Financial leverage

total assets ÷ equity = 2.5

1. 10% × 0.8 × 2.5 = 20%

The split shows how the 20% was achieved. Two companies with the same ROE can differ greatly: one may earn a high margin with little debt, another a thin margin with heavy borrowing. When ROE rises, check which part moved. An improvement in margin or turnover reflects better operations; an improvement driven only by higher leverage means more risk, not a better business.

A worked return on invested capital

Return on invested capital looks at the business as a whole, regardless of how it is financed. One common version divides operating profit after tax by the capital invested in the business, measured as equity plus net debt.

Continuing the example, operating profit is $1.5 million. Applying an assumed tax rate of 30% gives operating profit after tax of about $1.05 million. If equity is $5 million and net debt, from Chapter 5, is $5 million, invested capital is $10 million. ROIC is therefore about 10.5%.

Notice that this is lower than the 20% ROE. The difference comes from debt: shareholders’ return is magnified by borrowing, while ROIC shows the return the operations earn on all the capital used. ROIC is therefore the better guide to the quality of the business itself, and the right measure for comparing companies with different amounts of debt.

Compare returns with the cost of capital

A return means little in isolation. The useful question is whether it exceeds the return that investors and lenders require for the risk they take, often called the cost of capital. A business earning 10.5% on its capital when investors require, say, 9% for its level of risk is creating value; one earning 6% on the same basis is not, even if it reports a healthy profit.

The cost of capital cannot be observed directly and depends on interest rates, the riskiness of the business and judgement, so treat any figure as an estimate. The practical point is simpler than the theory: a business should earn comfortably more on its capital than safer alternatives would offer, and it should do so consistently, not just in good years.

Returns on the extra capital

A company’s average return can stay high even if its new investments earn little, because the average includes older, highly profitable assets. Looking at the return on the capital added over several years shows how well recent investment has done.

Suppose that over five years, operating profit after tax rose from $0.8 million to $1.05 million, an increase of $0.25 million, while invested capital rose from $7 million to $10 million, an increase of $3 million. The return on that incremental capital is about 8.3%, below the business’s average of 10.5%. The company is still profitable, but its recent investments are earning less than its existing ones, which may mean its best opportunities are behind it, or that recent projects have not yet reached full earning power. Either way, it is a question to put to the next annual report.

The price of a buyback decides whether it helps

Whether a share buyback benefits continuing shareholders depends on the price paid compared with what the shares are worth. This is an illustration. Suppose a company with 10 million shares is worth $120 million, or $12 per share, and spends cash on buying back 1 million of its shares.

• If it pays $15 per share, it spends $15 million. The remaining value is $105 million across 9 million shares, about $11.67 per share, a loss for those who did not sell.
• If it pays $8 per share, it spends $8 million. The remaining value is $112 million across 9 million shares, about $12.44 per share, a gain for those who held on.

Figure 4The same buyback at two prices

	Bought back at $15	Bought back at $8
Cash spent on 1m shares	$15m	$8m
Value remaining	$105m	$112m
Value per remaining share	About $11.67	About $12.44

In both cases, earnings per share would rise, because there are fewer shares. EPS growth alone therefore cannot tell you whether a buyback was a good use of cash. The price paid, compared with a sensible estimate of value, is what matters.

New shares dilute existing owners

The reverse also applies. When a company issues new shares, whether to raise capital, to pay for an acquisition or through employee share and option plans, each existing share represents a smaller part of the business. If the company receives fair value for the new shares, existing owners may not be worse off. If shares are issued cheaply, or issued steadily through generous incentive plans, existing shareholders bear the cost.

Track the number of shares on issue over five or more years. A count that rises a few per cent every year, while profit grows only modestly, means the growth per share is much weaker than the headline growth suggests.

Use average balances, and be consistent

Profit is earned over a year, while balance-sheet figures are taken on a single date. Dividing a year’s profit by the equity or capital at the year end can mislead when that figure changed a lot during the year, for example after a capital raising or a large acquisition near the year end. Using the average of the opening and closing balances gives a fairer result, which is why the ROE formula above uses average equity.

The precise method matters less than consistency. Different sources calculate ROIC in different ways: some include goodwill, some exclude cash, some use pre-tax profit. When comparing companies or years, calculate the measure yourself in the same way each time, rather than mixing figures from different sources that may have been prepared on different bases.

Returns when much of the capital is goodwill

For a company that has grown by acquisition, a large part of its invested capital may be goodwill. Calculating ROIC with and without goodwill tells two different stories, and both are useful.

Excluding goodwill shows how profitable the underlying operations are on the tangible capital they use, which is often very high for service and software businesses. Including goodwill shows the return on everything shareholders have actually paid for, including the premiums paid in acquisitions. A business with an excellent return excluding goodwill but a modest return including it has strong operations that were bought at full prices. That is worth knowing before judging the next acquisition.

Judge returns over a full cycle

As with margins, returns in cyclical industries can swing widely. A mining services company might earn exceptional returns at the top of a commodity cycle and very low ones at the bottom. The average return across a full cycle is a better guide than any single year, and the lowest year shows how the business copes under pressure.

Be particularly wary of extrapolating peak returns. If a company’s ROIC has recently risen well above its long-run average, ask whether competition, prices or demand are likely to bring it back down, rather than assuming the new level will persist.

Listen to how management talks about capital

The way management describes its decisions about capital is revealing. Some companies explain clearly how they decide between reinvesting in the business, acquiring others, paying dividends, buying back shares and repaying debt, and they report the returns earned on past decisions. Others describe growth targets and acquisition plans without ever mentioning the return on the capital required.

Look for management that sets out its required returns before investing, reports honestly on projects that fell short, and is willing to return cash to shareholders when it has no good use for it. Over many years, those habits tend to matter as much as the quality of the original business.

A five-year view of returns and shares

Putting returns and the share count side by side over five years shows how growth has really been achieved. These figures are fictional and continue the example above:

Net profit grew by about 43% over the period, a figure a company might highlight. Earnings per share grew by about 29%, because the number of shares rose by about 11%. And ROIC drifted down from 11.4% to 10.5%, because invested capital grew faster than operating profit.

Figure 5The same five years, three different growth stories

	Change over five years	What it shows
Net profit	About +43%	The headline
Earnings per share	About +29%	Diluted by about 11% more shares
ROIC	11.4% down to 10.5%	Each new dollar earned a little less

None of these trends is alarming on its own. Together, they describe a company that has grown by investing more capital, at slightly declining returns, and partly funded by issuing shares. Whether that is acceptable depends on whether the returns still exceed the cost of capital and whether the trend continues. The point is that the headline profit growth tells only part of the story, and the per-share and return figures tell the part that matters most to an owner.

How returns and reinvestment drive growth

A simple relationship links returns, reinvestment and growth. If a business reinvests a share of its operating profit after tax back into the business, and earns its usual return on that reinvestment, its profit grows at roughly:

Growth ≈ Return on invested capital × Reinvestment rate

For example, a business earning 10.5% on its capital and reinvesting 40% of its operating profit after tax would grow its operating profit by roughly 10.5% × 40% ≈ 4.2% a year. To grow faster without borrowing or issuing shares, it must either earn a higher return or reinvest a larger share. A company forecasting rapid growth while reinvesting little, at modest returns, is promising something the arithmetic does not support, unless it can explain where the extra growth will come from.

Key takeaway

Look for businesses that use capital productively and maintain that performance as they grow, without taking excessive risk.

Quick reference

• Check five-year profitability, share count and equity trends.
• Explain why ROE changed.
• Compare returns with the cost and risks of financing.
• Review whether new investments are generating useful results.