Metrics for a Good Business: Current Earnings or Platform for Future Earnings?
Friday, October 28, 2011 at 11:40AMLegendary investor Bill Ruane said this about good businesses:
The single most important indicator of a good business is its return on capital. In almost every case in which a company earns a superior return on capital over a long period of time it is because it enjoys a unique proprietary position in its industry and/or has outstanding management. The ability to earn a high return on capital means that the earnings which are not paid out as dividends but rather retained in the business are likely to be re-invested at a high rate of return to provide for good future earnings and equity growth with low capital requirement.
Based on his description, Amazon.com ($AMZN) is a good business. It has high returns on capital. Look at the stock price trajectory since its IPO. It is up about 200 times. In addition, $AMZN is drowning in reinvestment opportunities. Yet, when the company puts capital towards these investment opportunities, GAAP requires that they be classified as “operating expenses”. As a result, earnings are negatively impacted and the bears come out to sell.
$AMZN confuses the heck out of investors. How should we classify the investments it makes in its own platform? Are they capital expenditures or operating expenses? Jeff Bezos’ 2010 annual letter to shareholders shed some light on the subject. Here is what he had to say:
All the effort we put into technology might not matter that much if we kept technology off to the side in some sort of R&D department, but we don’t take that approach. Technology infuses all of our teams, all of our processes, our decision-making, and our approach to innovation in each of our businesses. It is deeply integrated into everything we do.
At $AMZN technology is an integral part of operations, current and future.. Current earnings are depressed because some of its operating expense are investments that will generate payoffs 3 to 5 years down the road. Current earnings suffer but the platform value compounds nicely over time.
Cash, earnings and the business platform are all economic assets. In the case of $AMZN, Jeff Bezos is clearly investing in the platform for the long term. Bezos is doing the right thing.
Written by Michael Bigger. Follow me on Twitter and StockTwits.
Reader Comments (2)
I saw your long DOV-CAT spread call this morning. When you do such a thing are you strictly looking at the historical price relationship/cointegration of the prices...or do you also have some sort of fundamentals based metric?
for instance you assume cointegration will hold AS LONG AS earnings growth or revenue growth for DOV is within some range of the same metric for CAT? or perhaps if one type of equipment maker was more dependent on the mining segment and one was more in the agriculture segment(perhaps not true for this example but bear with me) then assuming the cointegration will hold as long as copper vs corn remains in some range?
No, we just look at the stats and then put the proper price and time stops. We keep it very simple.