Value investors typically go after companies trading at attractive valuation levels, many times focusing on ratios such as price to earnings, price to free cash flow, or dividend yield, among many other possibilities. These kinds of indicators can be great tools when used correctly.
However, investors tend to put too much weight on these metrics, and they usually miss the forest for the trees when making investment decisions.
Value and profitability are two sides of the same coin
When talking about value investing, we usually think about companies that trade at low prices in comparison to fundamental indicators of value, such as earnings, cash flows, or dividends. However, these ratios are nothing more than shortcuts to identify investments with attractive potential. Valuation ratios don’t really tell us if the business is undervalued or overvalued.
Value investing is essentially about buying companies for prices below the company’s intrinsic value. On occasions, current earnings are a good indicator of the company’s intrinsic value, but that is not always the case. It’s of utmost importance to remember that the value of the business really depends on the cash flows that such business will generate in the future.
Sometimes a company can trade at a relatively high valuation ratio based on current earnings. However, due to the company’s ability to generate profitable earnings growth in the future, such price can be a bargain in disguise for investors.
For example, Apple (AAPL) was trading at a price to earnings ratio above 60 in 2005, which would seem clearly expensive in comparison to other stocks in the market. However, the business was growing rapidly and generating impressive returns on capital. Since then, Apple stock has produced a cumulative return of more than 3,400%. In retrospect, Apple was substantially undervalued in 2005, no matter what the price to earnings ratio was indicating.
Conversely, Sears (SHLD) was trading at a price to earnings ratio below 13 in 2007. Fast forward 10 years, and the company has burned massive amounts of cash, and the stock has lost 90% of its value in the last decade. Even if valuation ratios for Sears were temptingly low 10 years ago, the stock was clearly overvalued at the time.
Some key aspects to consider when thinking about valuation, growth, and profitability
- At the end of the day, value investing is essentially about buying a company for less than what the business is worth. Typical valuation ratios can be useful tools, but they don’t even begin to tell the whole story when calculating a company’s intrinsic value.
- A company’s ability to generate elevated returns on capital and to reinvest a big share of retained earnings at such elevated rates of return is the main driver of long-term value creation for investors.
- Many investors tend to underestimate the degree to which profitable growth can impact the value of a business.
An illustrative example
The following example from an excellent article by Base Hit Investing explains this dynamic quite graphically. Let’s assume two hypothetical companies, the first one is called Reinvestment Corp., and this high-quality business can reinvest all of its earnings at a 25% return rate. Since the business is so profitable, the stock is trading at an above-average price to earnings ratio of 20.
The second company is called Undervalued Corp. This company reinvests only 50% of its retained earnings, with the remaining 50% going to dividend payments. Return on investment is 10%, and the stock trades at an attractively cheap price to earnings ratio of 10.
In real life, chances are that Reinvestment Corp. will continue trading at higher valuation multiples than Undervalued Corp. as long as it continues generating superior returns on capital. However, the example assumes that both stocks trade at the same price to earnings multiple of 15 after 10 years.
Undervalued Corp. was much cheaper to begin with, and it was benefited by an expanding valuation ratio. Reinvestment Corp., on the other hand, was trading at a price to earnings multiple of two times the valuation assigned to Undervalued Corp., and it was punished by the market with a compressing valuation ratio.
Nevertheless, investors in Reinvestment Corp. still made much bigger returns than those in Undervalued Corp. due to superior earnings growth. Over a decade, Reinvestment Corp. produced an average annual return of 21.5% versus an annual return of 13.6% for Undervalued Corp.
Source: Base Hit Investing
The longer the time horizon, the bigger the impact that business profitability has on value creation, and hence on shareholder returns. Like Warren Buffett said: “Time is the friend of the wonderful company, the enemy of the mediocre.”
Warren Buffett’s co-pilot, Charlie Munger, explained how investing in companies with elevated returns of capital has been a key building block in his spectacularly successful investing career.
“We have really made the money out of high-quality businesses. In some cases, we just bought the whole businesses. And in some cases, we just bought a big block of stock. But when you analyzed what happened, the big money has been made in the high quality businesses.
Over the long term, it is hard for a stock to earn a much better return than the business, which underlies its earnings. If the business earns 6% on capital over 40 years and you hold it for 40 years, you are not going to make much different than a 6 % return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you end up with one hell of a result.”
A simple and powerful indicator
Using data from Portfolio123, when can build a simple stock screen that looks for companies with a return on investment – ROI – ratio above 20%. Among the companies that meet the 20% threshold, the screen selects the 100 names with the highest ROI levels.
The screen could easily be improved by including other profitability metrics in order to have a more complete look at the company’s profitability. We could also include other factors such as growth or valuation to build a more comprehensive screen. However, that’s beyond the point, the main idea is showing how a simple and straightforward criteria can produce impressive returns over time.
Based on back-tested results, the 100 companies with the highest ROI ratios in the Russell 3000 index produced a cumulative return of 1,033% since 1999, downright crushing the index and its cumulative total return of 121% in the same period.
In case you are wondering which companies make the list nowadays, the full list of companies with the highest ROI levels in both the Russell 3000 and the S&P 500 will be available to subscribers in my exclusive research service, The Data Driven Investor.
Value investing is about much more than buying companies with low valuation ratios. The value of the business ultimately depends on long-term cash flow generation, and companies with exceptionally high profitability can increase shareholder value exponentially over the years.
Price is what you pay, and value is what you get. Many investors put too much attention on price, while focusing on profitability and long-term value creation can produce superior returns over the years.
Disclosure: I am/we are long AAPL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.