If you can find a profitable company, you've got a great investment, right? Not so fast! Just because a company makes a profit, doesn't necessarily make it a great investment.
Don't get me wrong, being profitable is far, far better than the alternative — but there are plenty of examples of profitable business that have proven to be terrible investments.
There are two main reasons; which basically boil down to growth and cash. And the price you pay, of course… more on that below. Put simply, though — the more company a cash has, the more it can pay you in dividends!
Let's take a look at engineering company UGL (ASX:UGL). Over the past decade, the business has been consistently profitable. In fact, per-share earnings have actually grown by more than 12% over the period. Unfortunately, that hasn't been enough to deliver market-beating returns for shareholders.
The average growth rate — of around 1% per year — was disappointing, but isn't the main reason for the company's poor share price performance — with an annualised total shareholder return of -2.4% per annum!
Or another example: embattled wholesaler, Metcash (ASX:MTS). If we ignore the recent non-cash writedown, its underlying profit, on a per share basis, has actually grown by almost 29% over the last decade. That's not bad, and better than Telstra (ASX:TLS)– but the shareholder returns have significantly diverged.
What's important is that you pay a sensible price for that 'low growth' performance. Telstra's per-share earnings growth hasn't even kept pace with inflation over the past ten years, but shareholders have done well because the share price a decade ago was very modest, and much of those earnings have been paid out in dividends.
The difference is that ten years ago investors were paying an average of $19 for every dollar of Metcash's profit (giving it a P/E of 19) — a hefty premium and one that demanded a much better growth than what has been achieved. You probably don't need me to tell you that shareholders have lost plenty of money over the period, despite all the dividends that have been paid.
As the saying goes, you pay a high price for a cheery consensus.
Aside from growth, investors also need to consider how much of a company's profit is really available for shareholders. Some companies require a lot of ongoing investment just to sustain operations, and that means that most of the profit a company makes must be invested back into the business. There is no better example than the miners.
Even shareholders in the biggest and best miners suffer from this challenge, and as a result returns can be rather uninspiring. Over the course of the mining boom, which the RBA reckons took off in 2005, BHP Billiton (ASX:BHP) has delivered a total return (that is, with dividends included) of 8.6% per annum, on average. That's not terrible — far from it — but if that's what you do when there is a strong wind at your back, I'd hate to think what happens when things get tough. (Although, given what's happening with China and commodity prices, we may not have to wait too long to find out!)
Between 2005 and the most recent full year financial period, BHP made a whopping $139.5 billion in net profit in aggregate. But because mining is such a terribly expensive operation, only about a third of that made it into the pockets of shareholders.
Although BHP retained about $94-odd billion of all the profit made over the period, the company's market value has only increased by about $82 billion. Over the same period, its net profit has grown by about 87%.
The economics are, well, pretty ordinary. And this is one of the more successful mining companies!
Now consider one of the star dividend-paying companies on The Motley Fool Dividend Investor scorecard. Out of respect to our members I won't disclose it, but I will say that it is very typical of the kind of companies we like, and you'll see why in a moment.
Since 2005, over 70% of its profits were handed back to shareholders. Because the business doesn't require a lot of reinvestment to sustain operations, it could do this without undermining future profitability.
In the past decade, this company has retained $116-odd million in profit, but the market value of the business has grown by about $832 million and profit has grown by a massive 261%.
Compared with BHP, it's chalk and cheese.
Foolish Takeaway
If you prefer to avoid excessive risk, and if you like the idea of receiving regular dividends, focusing on established and profitable businesses is a great place to start — because they're often the most successful!
But it is also critical to ensure that the price you pay is sensible relative to growth expectations. It's also a huge advantage to invest in companies that do not require large amounts of ongoing investment.
The more money a company can afford to pay you in dividends, the better off you'll be!
Those are the sorts of companies we look for at Motley Fool Dividend Investor — strong, growing businesses that have lots of the folding stuff to pay to it shareholders in dividends.
If you're the sort of investor that likes growth and dividends, then Motley Fool Dividend Investor is for you. Start your membership today by clicking this link.
