A company can report record profits and still see its shares fall, while a loss-making business may continue to gain value. The difference is that investors assess not only current results, but also the cash a company may generate in the future and the risks involved.
Four factors help explain that valuation: revenue growth, operating margins, reinvestment needs and the cost of capital. They work together, so improvement in one area may be offset by deterioration in another.
Growth creates value only when the returns on additional investment exceed the cost of that capital. For example, a company that invests R$100 million to generate R$5 million in additional annual operating profit after taxes earns a 5% return on that investment. If its cost of capital is 12%, the expansion is not adequately rewarding the resources used. The business may be growing while destroying value.
Operating margins also matter because they show how much revenue becomes operating profit. A company with R$1 billion in revenue and a 25% margin generates R$250 million in operating profit, compared with R$100 million for a company with the same revenue and a 10% margin. But high margins may not last. Cutting research, maintenance or customer-service costs can boost results temporarily while harming future competitiveness. Margins elevated by favorable commodity cycles may also be treated as temporary by investors.
Reinvestment needs determine how much operating cash remains available to investors. Consider two companies that each generate R$200 million in annual operating cash after taxes. If one must reinvest R$150 million and the other just R$50 million, their free cash flow is R$50 million and R$150 million, respectively. If their growth prospects and risks are otherwise alike, and the difference is sustainable, the second company may be worth more. However, substantial investment can still add value if it earns strong returns.
The cost of capital reflects business risks and the return required by those who finance a company. A higher rate reduces the present value of future cash flows. For instance, R$100 expected in a year is worth about R$91 today at a 10% required return, but about R$83 at 20%. This helps explain why shares can fall even when a company remains profitable: higher interest rates may raise the return investors demand and lower the value they assign to future results.
These factors can shift at the same time. A company may become less risky but lose growth opportunities, with the reduced risk supporting its valuation and weaker prospects weighing against it. Likewise, a record profit may not lift a stock if results fall short of expectations or investors’ outlook for growth, margins, reinvestment or risk worsens.
The central question for investors is not simply whether a company is growing or profitable. It is how much cash it can generate for shareholders, how much it must invest to do so and what risks it faces. The article is by Michael Viriato, a wealth planner and co-founder of Casa do Investidor.
Sources: Folha Mercado.