Earnings 1_jpg_475x310_q85

I’d like to offer the opportunity to invest in my new business. No not the new Montgomery retail fund (although I’d be delighted to welcome you as an investor) but an operating company. Like many of the companies reporting earnings this reporting season I will guarantee it will report to you record earnings every year.

This promise is easier to keep than you might initially realise. If companies making such headline-grabbing announcements impress you, then you might be interested to know its not that hard to achieve.

All you need is a bank account and a rocking chair. Lets start with a million dollars in a bank account earning five per cent. First year earnings will equal fifty thousand dollars. Now let’s reinvest all of the interest. Now we have $1.05 million earning five per cent. Year two’s earnings would be $52,500. And there you have it, record earnings! Magic.

When a company reports record earnings, there is nothing more miraculous than the power of compounding. Indeed, if a company cannot increase its earnings, then perhaps a bank account is better.

Lets quickly look at a second example. Suppose after year one we have $1.05million and then our Great Aunt Betty bequeaths another million to us. With $2.05 million earning five per cent for a year, we will report record earnings of $102,500. Importantly, not only have we generated record earnings in year two, but we have also increased earnings by over 100 per cent. More Magic and what a brilliant company!

And all we needed to produce this trick is a bank account, a rocking chair and a benevolent shareholder Aunt.

All earnings are not created equal. To really sort the wheat from the chaff, we need to understand not only the change in earnings, but the change in the amount of equity on the balance sheet required to achieve it.

Take Silverchef a company that sells kitchen equipment to cafes and restaurants and finances other commercial equipment. For 2012 the company’s profit grew by 34% from $6.7 million to $9 million. This is impressive but the trick is to compare the result to any changes in the equity required to produce it. Has Great Aunty Betty given the company more money? In the case of Silverchef the answer is yes, the company has had the benefit of an additional $10 million of equity.

If you like, the additional equity has contributed an additional $2.3 million of profit. The company has generated a 23 per cent return on the additional equity. It is impressive but it is a function of the additional equity contributed by shareholders, in this case through a capital raising called an ‘Accelerated Non-Renounceable Pro Rata Entitlement Offer’.

To be fair the equity was raised in March 2012 and so the company has only had the benefit of the $10 million in capital since March – a mere three months. In the six months prior to June 30, 2012, the company earned a profit after tax of $4.9 million. Halve the result and we get $2.45 million earned over three months to June 30 2012 compared to approximately $1.8 million for the prior corresponding period. The additional $10 million for three months has produced an additional $650,000. Annualised, this is worth $2.6 million or 24 per cent on the ten million. The next time Silver Chef wants some money, Aunty Betty should ready herself to write the cheque because Bank West isn’t offering 24 per cent.

Contrast this to telco M2 telecommunications. Annual profit grew from $27.6 million to $33 million. To produce this growth in profit, the company sought an additional $84 million in April and May 2012 from shareholders for an acquisition (we’ll ignore the additional $140 million of debt). M2’s second half profit of $16.3 million was only $200,000 than the corresponding period in 2011. Divide it by six and multiply by the one month it had the additional money and you get $33,000. Annualised, it doesn’t look like such a great return on the additional capital.

Admittedly, M2 reckons it will earn at least $43 million in 2013 or an additional $10 million above 2012. If it does, the improvement is equivalent to a bank account earning 11.9 per cent. I’ll take Silver Chef’s 24 per cent thank you.

Markets tend to focus on earnings growth and the reporting of record profits but even ABC Learning’s Centres was growing its earnings every year while returns on equity were in decline. Focus on the dollars required to produce the profit and you will easily navigate reporting season and steer your super fund safely through the tempest.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564) and may contain general financial advice that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs.

3 thoughts on "Montgomery University - "When Earnings ain’t Earnings""

  1. Hi Roger,

    So we see that ROE is declining in the case of M2 and increasing in the case of SIV when we compare latest financial year earnings to the previous available.

    You have taught us well, that we know we need to look at companies who’s ROE’s are increasing – that much is clear. Your figures do not consider retained earnings, so the incremental returns are actually significantly worse than what you quote above. Both companies look like the ROE’s are flattening out (SIV less so, but SIV is debt turbocharged a little too high for my liking).

    Your post lead me down another investing thought path. When is equity not equity? Most of the high quality companies are still fully valued (as far as I see) and there seems to be only a smattering of value turning up in the mining services companies. But we know thanks to your timely warnings that there are clouds on the horizon that are perhaps not factored into FY 2014 earnings. One of those companies that are ranked highly by Skaffold is ALQ, the former CPB. They have an unbelievable track record of returns to shareholders, but one thing that looked like a negative to me was the high Intangibles at over 80% of investors equity. They must have overpaid for acquisitions in the past (big change recently) and perhaps added to Intangibles with capital works but it seems to be working. ROE has increased recently on increasing debt. Future ROE is forecast to decline, but you also told us what to think about analyst forecasts….

    Still, just doesn’t convince me as an investment case at the moment, but I am really wondering what I am missing because I know there must be something out there worth investing in with the recent volatility it just doesn’t seem that obvious to me. That must be another reason why I should try and scrape together some money to put in your fund. This investing game is tough. Buffett said if you are in a poker game and a few hands in you don’t know who the Patsy is, it must be you. Perhaps that is what has happened the last decade of my investing life, but I hope to change that. Living in optimism,
    Matt

  2. Thanks a lot for sharing your insights, Roger. Very useful, indeed. Personally ROE, ROCE, ROIC metrics are the kinds I try to focus the most.

Post your comment