The True Value Ceators of the DJIA
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The term "growth" is often used in the investment community, although it is generally thrown around rather vaguely or with a variety of possible meanings. The term can appropriately describe a firm that has experienced meaningful increases in sales volumes, earnings, or shareholders' equity balances over a particular period, or even a firm that has made strides in expanding its worldwide footprint through the construction of additional foreign operations bases.
Despite the variety of instances in which this popular term can be used, there's one thing that many investors are sure they know with certainty – all growth is good, and paying more for a so-called "growth stock" is a sure way to experience hearty investment gains in the long run.
What most of these investors do not appreciate is that not all growth is directly in line with shareholder interests, and not all growth creates meaningful long-term value. Investors should be warned against paying too much for the growth of such metrics as sales and earnings, as growth in these areas alone is not necessarily a good measure of a firm's value-generating ability. For example, sales and earnings growth can be created by investment that does not generate returns above the firm's cost of capital requirements (read more about Tyco's (NYSE: TYC) mass acquisition streak in the late 1990s and early 2000s). Likewise, aggressive accounting methods, which obviously are not value-creating, can be utilized to report growth in these areas.
Instead of being fooled by and paying for these superficial boosts, getting deeper into a firm's accounting numbers will yield a higher understanding of the firm's operations and its true value-generating abilities. More specifically, a residual earnings valuation, which charges the firm for its "required" level of earnings, not only protects the investor from paying too much for non-value creating growth, but also actively identifies firms that will create the most value over the long run.
A simple residual earnings exercise, utilizing the 30 large industrial firms comprising the Dow Jones Industrial Average, acts as a suitable example.
Note—"Residual Earnings" in the study was calculated as (Net Income / Average Equity) = Return on Common Equity. (Return on Common Equity – Cost of Capital) * Average Equity = Residual Earnings. Because the study is simply looking at the change in residual earnings over the five-year period, as opposed to the absolute level, any cost of capital can be used. This particular study uses a reasonable 10% for all firms.
Over the past five years, four value-creating firms stand out in particular – Intel (NASDAQ: INTC), IBM (NYSE: IBM), McDonald's (NYSE: MCD), and Wal-Mart (NYSE: WMT). Collectively, these four corporations have increased their residual earnings by an annual average of 23.94%, whereas the average five-year CAGR in residual earnings growth for all firms in the DOW was only 3.4%.
What is more intriguing than the fact that most firms in the average have not created much shareholder value over the past five years is that these four select firms have also experienced significantly higher per share price appreciations over the study period. An investment stake held in Intel, IBM, McDonald's, and Wal-Mart since early January 2007 would have generated an average yearly return of 13.49%, whereas purchasing and holding the entire DJIA would have returned -0.2% CAGR (essentially breaking even) over the same timeframe (simply looking at price appreciation, not including dividends).
Although the sample size was relatively small compared to the entire universe of publicly traded stocks, as was the example's five-year study period, there does appear to be a noticeably positive correlation between investment returns and a firm's ability to generate meaningful shareholder value. Actively seeking out these value-creators does appear that it would pay off in higher-than-average investment returns in the long run, so more closely examining the operations of these four firms over the past five years can shed light on the drivers of value creation.
This is the first of a five-article series that will examine what makes these four special DJIA firms tick. The following value-creation framework will be utilized to determine how these corporations have been able to more effectively drive residual earnings growth than the competition.
gibbstom13 has no positions in the stocks mentioned above. The Motley Fool owns shares of International Business Machines, Intel, and McDonald's. Motley Fool newsletter services recommend Intel and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.