Graham Holdings Company (NYSE:GHC): Assessing Capital Returns

I am writing today to help inform people who are new to the stock market and want to begin learning the link between Graham Holdings Company (NYSE:GHC)’s return fundamentals and stock market performance.

Purchasing Graham Holdings gives you an ownership stake in the company. This share represents a portion of capital used by the company to operate the business, and it is important the company is able to use the capital base efficiently to create adequate cash flows for you as an investor. Your return is tied to GHC’s ability to do this because the amount earned is used to invest in opportunities to grow the business or payout dividends, which are the two sources of return on investment. To understand Graham Holdings’s capital returns we will look at a useful metric called return on capital employed. This will tell us if the company is growing your capital and placing you in good stead to sell your shares at a profit.

What is Return on Capital Employed (ROCE)?

As an investor you have many alternative companies to choose from, which means there is an opportunity cost in any investment you make in the form of a foregone investment in another company. The cost of missing out on another opportunity comes in the form of the potential long term gain you could’ve received, which is dependent on the gap between the return on capital you could’ve achieved and that of the company you invested in. Hence, capital returns are very important, and should be examined before you invest in conjunction with a certain benchmark that represents the minimum return you require to be compensated for the risk of missing out on other potentially lucrative investments. We’ll look at Graham Holdings’s returns by computing return on capital employed, which will tell us what the company can generate from the money spent in operations. I have calculated Graham Holdings’s ROCE for you below:

ROCE Calculation for GHC

Return on Capital Employed (ROCE) = Earnings Before Tax (EBT) ÷ (Capital Employed)

Capital Employed = (Total Assets – Current Liabilities)

∴ ROCE = US\$281m ÷ (US\$4.9b – US\$804m) = 7.7%

GHC’s 7.7% ROCE means that for every \$100 you invest, the company creates \$7.7. A good ROCE hurdle you should aim for in your investments is 15%, which GHC has failed to reach, meaning the company creates an unimpressive amount of earnings from capital employed.

Why is this the case?

Although Graham Holdings is in an unfavourable position, you should know that this could change if the company is able to increase earnings on the same capital base or find new efficiencies that require less capital to produce earnings. Therefore, investors need to understand the trend of the inputs in the formula above, so that they can see if there is an opportunity to invest. If you go back three years, you’ll find that GHC’s ROCE has increased from 5.9%. The movement in the earnings variable over this time shows a fall from US\$307m to US\$281m, but the use of capital has fallen further due to a decline in total assets employed , indicating that the previous decline in earnings has not destroyed ROCE because the company now has smaller capital needs to operate the business.

Next Steps

ROCE for GHC investors is below the desired level at the moment, however, the company has triggered an upward trend over the recent past which could signal an opportunity for a solid return on investment in the long term. But don’t forget, return on capital employed is a static metric that should be looked at in conjunction with other fundamental indicators like future prospects and valuation to determine if an opportunity exists that isn’t made apparent by looking at past data. Graham Holdings’s fundamentals can be explored with the links I’ve provided below if you are interested, otherwise you can start looking at other high-performing stocks.

1. Future Outlook: What are well-informed industry analysts predicting for GHC’s future growth? Take a look at our free research report of analyst consensus for GHC’s outlook.
2. Valuation: What is GHC worth today? Despite the unattractive ROCE, is the outlook correctly factored in to the price? The intrinsic value infographic in our free research report helps visualize whether GHC is currently undervalued by the market.
3. Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.