Focussing purely on results is dangerous for businesses, investors and their wealth. Any quick scan of the financial media will produce article titles something similar to this:
Example Ltd. Increases Earnings by 20% to $60m
The article will then usually dive into praise about which divisions produced the growth, how much their revenue grew by, and the fantastic manager that produced the performance. Earnings is something any reader can understand, it requires little effort to produce such analysis, and outcomes are what really matters, right?
Unfortunately, increasing earnings is not just good news. Indeed, it can be hiding terrible news. Focussing on the outputs of any entity is dangerous if done in isolation of the inputs.
Let’s step away from businesses and just look at a similar headline written about Jim. Jim has a bank account that earns interest. The interest he earned on his account increased this year compared to last year. So impressive was his earnings growth, that an article was written about it in the financial press:
Jim Increases Earnings by 20% to $6k
Just like the heading above, it looks like great news. Outputs have increased, who could have a problem with that? Kate, Jims wife might. Jim increased the bank account’s earnings by 20%, but he put 100% more capital in to do it. Last year he earned $5k on $100k of their savings or about 5%. This year they earned $6k on $200,000 or 3%, much less impressive. Especially if other bank accounts have been increasing their interest rate.
Jim got more out, by just putting more in. There’s nothing impressive about that. Any fool can generate “record earnings” by just adding more to their savings account. The interest of the bank account might have increased compared to last year, but the interest, relative to the savings they put in has been terrible. No one reading this would look at the details of what Jim has earned and think he’s done a good job.
But managers, investors and professional analysts can often let this logic slip by when the entity changes from a bank account to a business:
The management at ABC Learning pulled off the same magic as Jim and his bank account on a much grander scale. To fanfare and general admiration, the childcare company grew profits from $3.2m in 2001 to $143m in 2007, a rate of 88%pa. The stunning profit growth is eclipsed by how quickly investors were willing to give it more money. Investors injected $1.88 billion between 2001 and 2007. Equity invested grew from $13m to $1,901m in 2007. Investors had done even better than Jim, they had increased earnings 4400%, but it was done by just shoveling money in. Indeed, 14,500% more money.
When the investors weren’t willing to dip into their wallets, the management team turned to the banks, sucking up a further $1.75 billion in debt along the way. Just like Jim’s bank account, the interest was rubbish. The return on equity in 2001 was $3.2m on 13m equity or a healthy 24%. The next $1.88 billion invested by investors generated additional earnings totalling just $140m, or about 7%. Investors would have earned more in the safety of a term deposit.
Every year, ABC broke its previous year’s profit record. Every year, the media and investors alike hailed the management team and its stunning profit growth. Investors lost sight of the inputs they were pumping in to generate those staggering outputs. One month after its 2007 record breaking profit, management announced that auditors would be “restating” the 2007 profits. Before 2008 ended, the once $4.1 billion business was effectively worthless.
This is not a lone example and other examples can be more extreme. Even more praise is paid to even worse performances. Businesses can happily hit the headlines every year “breaking profit records” while gorging on investor capital (or debt) to do it.
To generalise, if you’re the one supplying the inputs to an entity, judge the output of that entity relative to what you put in.
When you’re paying for the electricity, you might care to know how much energy each washing machine consumes to get the job done. When you’re paying for petrol and maintenance, you might like to be aware of how much each car will consume to get you from A to B.
Times when the efficiency of a machine doesn’t matter to you is when you aren’t the one supplying the inputs. It explains some interesting phenomena. Take salaried employees as an example. As a manager of a salaried employee, the output you’re interested in is “getting a task done”, the entity is the “employee”, and an input is the “employee’s time”. It might be nice to know which of your employees is the most efficient to get a job done. But salaried employees aren’t paid by the hour and the employee’s time is costless to the manager. This can lead to some interesting workplace dynamics.
Another interesting example is a solar panel array. Energy efficiency is a popular topic, but it’s not always relevant. In the case of a consumer purchasing solar panels for their home, the output is “electricity”, the entity is the “solar panel array”, and an input is the “sun’s rays”. At no point should a consumer care how efficient the panel is at converting the sun’s rays into electricity. The sun is effectively infinite and costless.
When I want to evaluate an entity of any kind, I think it’s healthy to be aware of all of its inputs and outputs, but close attention should be paid to the outputs that are yours to keep, and the inputs you had to provide yourself.
Why then, do the profits (outputs) get emphasised so much when looking at a business? Two key reasons that come to mind are the measurability of inputs, and the incentives of players in the system:
- Measuring the equity put into different parts of a business can take a lot more work than simply flipping to the accounts for the profit number. Things that are hard to measure get ignored.
- Player (management), is often incentivised and measured on profit, or even higher level outputs like sales. I suspect many top tier managers in larger companies could tell you the sales figures from last quarter to the dollar, but wouldn’t have a clue how much investor capital is employed in the business.
- Player (media), is incentivised by readership and ad revenue. Quick “click bait” doesn’t cost much compared to actual analysis but will generate the same or more page views.
- Player (investors), should care, but human thought idiosyncrasies get in the way. We overvalue the present relative to the future. When unsure, we do what the crowd does. We search for evidence that confirms our ideas and avoid evidence that refutes them, just to name a few.
Input/output measurement issues and player incentivisation can explain a lot of unexpected occurrences in business and outside of it. Breaking down a complex system into its different, inputs, outputs, players and incentives is half the enjoyment of investing.
Whether looking at a business, a bank account or a solar panel, I believe it pays to be aware of all the inputs and outputs. But I think it pays extra well to keep the outputs in context of what you put in.
Any fool can generate “record earnings” by just adding more to their savings account.