The True Value Ceators of the DJIA Part IV
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In this fourth article in a series of five (see the first three installments here, here, and here), a closer look will be taken at IBM's (NYSE: IBM) higher-than-average residual earnings generation ability. As hypothesized from findings discussed in the series' first article, there appears to be a positive correlation between long term investment returns and the active search for and purchase of firms that can consistently grow the earnings above and beyond their cost of capital.
Four specific DJIA firms -- IBM, Wal-Mart (NYSE: WMT), Intel (NASDAQ: INTC), and McDonald's (NYSE: MCD) -- were isolated for their ability to grow residual earnings on common equity more effectively than the entire DJIA average over the past five years. Whereas, collectively, the thirty DJIA firms grew residual earnings by a five year compound annual rate of only 3.4%, the four firms discussed in the series maintained average annual growth of nearly 24%.
Likewise, as mentioned in the first article, these firms also produced higher per share price appreciations over the five year period: 13.5% average annual return vs. -0.2% five year CAGR for an investor in the entire DJIA (not including dividends). From these results, it appears that the investing public rewards those corporations that have the ability to not just grow sales, earnings, or assets, but those that can specifically create long term shareholder value by increasing their earnings above and beyond their cost of capital requirements.
As in the first three articles, the following value creation framework will be used to analyze IBM's past five year operating performance. Refer to this illustration periodically throughout the article to see how the key drivers of residual income generation work.
Note- Be sure to revisit the first three articles to review additional definitions/calculations that are not explained in the following discussion.
Over the five year test period, IBM's residual earnings grew at a compound annual rate of 18.3%, and an investment in the corporation to date since early January 2007 would have yielded an average return of around 15.4% per year (not including dividends).
It is very positive for current and prospective IBM investors to note that the corporation has been able to continuously grow residual earnings through the primary improvement of its core business strategy. As will be further explained, IBM did in fact receive a favorable boost from leverage like Wal-Mart, but it has made much more significant strides in improving its core business than the other two firms thus far.
Primary Residual Earnings Drivers
In examining the change in IBM's residual earnings compared to its change in ROCE and its equity balance, it can be determined that the vast majority of the change in residual earnings over the past five years was explained by the change in the corporation's return on net assets. In fact, the company's common equity balance actually decreased over the test period by about 5.2% per year. In order to report a net increase in residual earnings, therefore, it took an even more impressive increase in ROCE to make up for the declining net asset base.
Remember that Residual Earnings = (ROCE - Cost of Capital) * Average Equity.
The company's return on common equity of 64.9% and 74.4% in 2010 and 2009, respectively, far outweigh the firm's five year average of 53% and its ten year average of 39.7%
There are several drivers behind the firm's higher return on common equity. First, IBM has been able to drastically improve its core business over the past several years, despite the rather inclement economic environment. IBM's return on its net operating assets (RNOA, defined as post-tax operating income divided by net operating assets) increased at an average annual growth rate of 20% throughout the study period.
This increase in RNOA was by far the largest influence in the firm's improvement of ROCE. However, similar to the findings in the Wal-Mart case, the corporation did receive a meaningful boost from financial leverage use. On average, the return on common equity was nearly 21% greater than the return on net operating assets over the five year period. However, unlike Wal-Mart, IBM's financial obligations balance remained relatively stable. This implies that the increase in ROCE was due to the two-fold effect of increasing RNOA figures coupled with a favorable enhancement due to increased leverage spread.
A further examination of the ROCE breakdown will explain (mind the small rounding error):
Net Borrowing Cost (NBC) = Post-tax Financing Cost (Interest) / Net Financial Obligations
Spread = Return on Net Operating Assets (RNOA) - Net Borrowing Cost (NBC)
Financial Leverage = Net Financial Obligations / Common Shareholders Equity
ROCE = RNOA + (Financial Leverage * Spread)
For 2010: 64.9% ROCE = 40.28% RNOA + (63.7% Leverage * 38.38% Spread)
For 2007: 36.6% ROCE = 24.64% RNOA + (54.7% Leverage * 21.80% Spread)
As depicted, in looking at 2010 and 2007 there was a 63% increase in RNOA and only a 16% increase in the firm's financial leverage. Because net borrowing cost remained relatively stable and there was a meaningful increase in RNOA, the firm's leverage spread also dramatically increased by 76%. Yes, the firm did receive a favorable boost from financial leverage (ROCE of 64.9% in 2010 was levered-up from a smaller 40.28% RNOA), but the effect was primarily from increases in RNOA and its favorable effect on spread. These are both signs of improvement in key business fundamentals.
There are several positive points to note. The corporation, as explained with its ROCE growth, has been able to grow its return on net operating assets at an increasing rate over the past ten years. Likewise, the growth in the return on IBM's core operating assets (RNOA) exceeds the growth on its common equity (ROCE). The strategic operating strategy shift the corporation has made over the past decade are behind this positive influence.
Starting in 2005, the corporation did not simply announce a global restructuring plan, but an entire overhaul of its core operating strategy. Instead of continuing to rely on commoditized businesses including PC hardware and hard disk drives, IBM management made the decision to capture additional share in the software, services, and financing sectors. Hardware, which once comprised about 30%-35% of the corporation's revenues, is now drastically overshadowed by the 90% services revenue source. As a result of this strategic initiative, a more favorable mix of profitable segments has allowed IBM to significantly increase its margins and overall profitability on a very similar asset base.
The extremely impressive growth in RNOA mentioned earlier is a direct result of asset turnover subsequently increasing 20% over the past five years (and 44% over the past ten years), and its gross and operating margins increasing every year over the past seven years. The improvement in margins explains a majority 90% of the positive change in RNOA, but all the same, both of the improved metrics are more in line with a streamlined corporation that focuses on providing a service offering.
Out of the three cases thus far, IBM has shown the most strategic initiative in terms of identifying shifting business trends and modifying its operations to capitalize favorably on the change. It takes a very special type of corporation to up and leave a business segment that has been its mainstay for several decades, and successfully streamline operations and shift operating focus. All of this goes without even mentioning that IBM completed this daunting task during one of the most dramatic economic downturns over the past half century, and the corporation continued to improve nearly all business metrics (sales, margins, earnings, asset efficiency, and residual earnings) along the way.
What does this success say about the corporation's ability to continuously grow its residual earnings? There is no doubt that IBM has a sustainable competitive advantage and a large degree of customer captivity; such a large corporation would not have the power to systematically change the course of its ship and simultaneously fend off hungry competitors if it did not possess some meaningful competitive moat around its operations.
What to look for in the next installment in this value-creation series? Seeing that the fast-food king McDonald's will be the subject of the next article, one can only assume that there will be additional discussion about the importance of sustainable competitive advantages in the ability to continuously grow residual earnings. The success of your long term investment returns may be improved by actively seeking out corporations that harbor these characteristics!
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.