A look at incremental ROCE

Many investors focus on increases in earnings. Perhaps “focus” is the wrong word. It is more like “obsession”. There are commentators that point out, though, that it is not growth in earnings that is important, but return on capital. Growth in earnings achieved by investing below the cost of capital is actually value-destructive.

I would take the idea of ROCE (Return on Capital) one step further: it is not return on capital per se that is important, but return on INCREMENTAL capital. Ideally, what investors want, or at least should want, are high returns on incremental capital, the opportunities to deploy capital at those returns, and a reasonable share price in relation to earnings.

I am growing fonder of Stockopedia’s cashflow statements. They give your 6 year’s worth of data, and it really lays out nicely how cash came in, and where it went.

I think you can also use it to see what a company’s incremental returns have been.

Take a look at spreadbetters IGG (IG Group), for example. For 12 m/e 31-May-2009, it generated operating cashflow of 56.8m. For ye/ 31-May-2014, it was 134.4m. That’s an increase of 77.6m.

The cash used for investing activities during that period was 159.5m (58.1+2.48+25.4+7.14+66.4).

So the return on incremental capital has been around 48.7% (77.6/159.5). That is phenomenal. Revenues have compounded at a rate of 8.9%pa. It pays a generous 4.1% dividend yield. Admittedly, there may be unusual distortions in cashflow there; but still, the company seems to be doing all the right things.

Two other companies that I had thought of as being good-quality companies: DPLM (Diploma) and HLMA (Halma) also, as it turns out, have good incremental returns on capital. DPLM is 22.4%, and HLMA is 16.8%. I think these companies will surprise us positively by the length of their growth. Unfortunately, their valuations are fairly high.

On the other side of the coin, companies that have a high ROCE, but lagging operating cashflows, are AZN (AstraZeneca) and IMT (Imperial Tobacco).

AZN reports that its average ROCE is 21.6%. However, its ROCE starts at 31.0% and ends at 5.9%. Looking at the cashflow statement, I see that it had operating cashflows of $11739m for y/e 31-Dec-2009, decreasing to $7058m for y/e 31-Dec-2014. Cash invested during that period amounted to $11440m. At least so far, AZN has invested a lot of money with little to show for it. The company’s “patent cliff” is well-publicised, and the company seems to have made some rash takeovers, so the poor performance does not seem surprising.

IMT has seen its cashflow from operating activities deteriorate from 3569m to 2502m. It does, however, have very modest capital requirements, having spent around 1304m over 5 years.

The section “Cash from financing activities” is another interesting area to look at. It gives a great overview of how how capital entered and left the company. Did the company pay out lots of dividends, issue or retire debt, or issue lots of equity? This section can bail you out of a lot of trouble with AIM companies. You may see that a company has a lot of cash, and think “that’s great”, only to discover that they had issued shares previously. Cash is good, but if it’s only there because shareholders just gave it to them, then, well, is that really so great after all?

I think that this is a big problem with many AIM companies. They focus on expansion. How do they expand? By tapping the equity markets. This will usually be a placing at a discount, where private investors are cut out of the deal. So incumbent shareholders can expect to be diluted. Not good, especially if the money wasn’t particularly well-spent.

So, I encourage you to make use of Stockopedia’s cashflow statements. It really does encapsulate a lot about companies in an easy-to-digest form.

May you all be well.

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About mcturra2000

Computer programmer living in Scotland.
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