What Investors Want: Part Two

What Investors Want: Part Two

almost 5 years ago1 min

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(This is part two of a series on what investors want. If you haven’t already, check out the introduction – entitled What Do Investors Want?)

Analysis from Goldman Sachs shows that companies which create persistent streams of recurring revenue – and therefore recurring profit – stand the best chance of being appreciated by investors over the long term 📈

Goldman analyzed the correlations between changes in companies’ share prices and a range of factors. It found that investors tend to pay more when companies increase their leverage (i.e. borrow more money) than for increases in the efficiency of their use of assets or a rising profit margin.

An increase in leverage has the biggest impact on a company’s valuation
An increase in leverage has the biggest impact on a company’s valuation

As the chart below shows, that’s because leverage tends to be highly persistent – boosting the returns companies make on their investments for a longer period than a higher profit margin, for instance. On the other hand too much leverage, which can make a company unstable, is equally persistent... 🤢

The effects of high leverage last longer than rising asset turnover or profit margins
The effects of high leverage last longer than rising asset turnover or profit margins

Goldman’s analysis helps explain why companies are incentivized to borrow more in an attempt to boost returns. For companies in the most predictable sectors – like telecoms – higher leverage can drive higher valuations, especially when economic skies are darkening 🌥️

Predictability is largely a reflection of analysts’ earnings forecasts, and how often companies actually meet their targets. Doing so is, unfortunately, more difficult for some complicated companies – like biotechs, which search for the next big drugs.

But for stable companies whose forecasts investors trust, rising earnings estimates – including those based on higher leverage – can have a big effect on valuations 🤑

Rising analyst expectations in stable sectors improve valuations the most
Rising analyst expectations in stable sectors improve valuations the most

Stay tuned for the next installment, where we'll explore why investors value companies which insulate their regular income from one-off windfalls. You know it's going to be good...

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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