George Salmon 1 February 2019
Investors have different goals.
Some people might want to grow their savings pot, whilst others might want a regular source of income. Whatever your aim, the most important part is finding a good company to invest in. One that can share its profitability with you.
There are two ways a company can do this.
The one most of us know about is through a dividend – companies can pay out some of their profits to shareholders. The one we hear less about is when a company reinvests profits back into the business. Shareholders don’t get a physical payment, but if the business can find profitable opportunities, it can help the share price rise.
Both options could give you the opportunity to grow your wealth. Remember investments can fall as well as rise in value and may not get back what you invested.
Start with the basics – cash comes first
To see if a company could help grow your money, you need to understand how well it generates profit and how it turns those profits in to cash.
Operating margins are a good place to start. This measures how well a company can turn sales into profit, and is simply profits divided by sales. What ‘good’ looks like will differ between industries, so it’s a measure you should compare with other companies doing similar things.
Growing operating margins could point to improving cost control or pricing power. But declining ones could be a warning sign.
It’s also worth looking at how well a company uses the money it has at its disposal – capital allocation. A good way to measure this is to look at a company’s ‘Return on Capital Employed’ (ROCE). That’s profits divided by the total amount of money (capital) invested in the business.
Like with margins, think about this in context. Different industries will have different norms, so comparing a company to its peers and its own record over time is important. A growing ROCE over time, or one consistently ahead of rivals, is a good sign.
Healthy margins and ROCE trends are good news – both for those looking for income and for those who want to see the value of their shares rise over the long term. Let’s see how.
The power of compounding is the key to growing your wealth with dividends. Reinvesting your dividends to buy more of the same investment means any future growth is applied to an increasingly bigger investment.
Profitable companies that use their money wisely should be able to keep paying a dividend, and grow it over time too.
Importantly, if a company can pay a steady stream of dividends, investors don’t need a rising share price to make money.
For example, a falling share price means a £1,000 investment in GlaxoSmithKline 20 years ago would only be worth £721 today.
However, the company has paid a steady flow of dividends over that time. That means investors would have been paid a total of £331 in income. Add the two together, and you get £1,052.
While that’s only a slight improvement on the original £1,000, if the dividends had instead been reinvested, the investment would now be worth close to £1,700. That’s almost 70% more than the original £1,000 investment, despite the shares falling in value.
Please remember past performance isn’t a guide to the future. Yields are variable and not guaranteed.
Rather than paying out profits to shareholders, some businesses might be able to put profits to good use internally. Maybe a new product line, or overseas expansion.
Reinvesting profits lets a company take advantage of opportunities to grow its value. If done well, shareholders could see the value of their investment grow faster.
How do we spot these companies? Those good at investing in projects that add value to the business will have a stable or rising ROCE.
As an example, we’ve taken a closer look at Boohoo, which has reinvested profits over the years, generating an ROCE of over 10% each year. It’s also yet to pay a dividend.
Those who invested at launch have been rewarded, with the share price rising from 70p to 189p at the time of writing. Of course, there are no guarantees this run will continue.
Boohoo’s reinvestment is directed towards maintaining its edge in the competitive arena of online fast fashion. This has seen continuous investment into IT and warehouse infrastructure – making sure the service is slick both inside and out.
Money has also been spent acquiring the brands PrettyLittleThing and Nasty Gal – diversifying Boohoo’s offering and opening up bigger markets, including in the US.
At the moment the reinvestment strategy seems to be working, but there’s no guarantee this will continue. For example, while the group has been flying high, a tough clothing market could bring it down to earth.
Margins and ratios – it’s what we’re here for
We know not everyone has the will, time or energy to go about finding profitable companies with a high and stable ROCE. That’s where we come in.
Sign up for share research updates
Each week we offer timely research from our dedicated team of Equity Analysts.
Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.
This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.