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international income investors could reap the rewards in the form of
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| Understanding
Return on Equity (ROE) |
Published: November 22, 2005
When measuring a
company's profitability, it is generally useful to have a measuring
stick that you can use to compare the earnings delivered by firms of
various sizes. For example, it is quite possible for a large company
that generates $1 million in annual net income to be only modestly
profitable, while a tiny micro-cap firm that produces just $100,000 in
yearly income could be considered enormously profitable. Obviously,
comparing just the profits -- $100,000 and $1 million -- in isolation
only tells us part of the picture.
While there are a number of financial measures that could also be used
to assess a company's overall profitability, one of the most revealing
is return on equity (ROE). The following calculation is a simple method
of determining how much net income a company generates per dollar of
shareholders equity.
ROE = Net Income/Shareholders Equity
Returning to the previous example, let's dig deeper into the small
company (ABC) and the large company (XYZ).
Suppose ABC reported total equity (assets - liabilities) of $400,000
last quarter, while XYZ reported a comparable figure of $10 million.
With this information, we can now calculate the ROE for each.
ABC -- $100,000/$400,000 = 25%
XYZ -- $1,000,000/$10,000,000 = 10%
By using ROE, we discover that while XYZ can be expected to generate far
greater profits than ABC in absolute terms, the company is much less
efficient relative to its level of shareholder equity.
A company that shows repeatedly poor ROE figures is likely to be
struggling. Conversely, if a firm routinely churns out above average
returns on equity -- particularly if ROE is holding steady or rising --
then it is a good sign that management is running the company
efficiently. However, by the time a company's success is reflected in
improving ROE figures, any improvements have probably already been
priced into the shares.
They key to being a successful value/contrarian investor lies in
recognizing those companies that are poised to generate stronger
financial results before the rest of the public can see any
improvements. You can accomplish this by breaking down ROE into the
components that influence the calculation and examining them
individually. Often, this will tell you that a company is heading in the
right direction before ROE (and the stock) begins to climb higher.
There are three main drivers of ROE: profitability, productivity, and
capital structure. The finance department at DuPont identified these
components as profit margins, asset turnover, and financial leverage.
Hence, a derivative of these inputs is known as the DuPont formula. When
a company is doing the right things for shareholders, it is common to
see improvements in each of these three areas. Naturally, companies with
stronger returns on equity -- all else being equal -- should be assigned
higher intrinsic values.
Too many investors make the mistake of keying exclusively on sales and
earnings and ignoring nearly everything else. After all, what good are
buckets of earnings if management foolishly squanders the profits with
ill-advised capital allocation decisions? Furthermore, even the
strongest earnings growth can be watered down with excessive options
dilution. Impressive growth rates may capture the headlines and prop up
a stock's price temporarily, but in the long run it will be impossible
to sustain if the capital structure is weakening and/or management does
not manage shareholders' capital effectively. For this reason, legendary
value investor Warren Buffett and others rely heavily on management
efficiency when evaluating prospective investments.
It should be reiterated, though, that ROE by definition is a
backward-looking tool based on past performance. While this information
is useful, a company's future direction is always of greater importance.
To better understand where a firm might be headed, it is essential to
analyze the underlying factors identified by the DuPont formula.
Before we go further, it's worth taking a moment to discuss the impact
of debt. There is nothing inherently wrong with leverage, provided
management can put the money to good use. In some cases, though, debt
can be used to distort the ROE picture. Furthermore, excessive debt can
create numerous problems, not the least of which is mounting interest
payments that can offset earnings growth. Thus, there is a marked
difference between a debt-free company with an ROE of 20 and a highly
leveraged one with an identical ROE. For this reason, the ROE formula
should be tweaked for debt-laden companies. The revised formula, known
as Return on Total Capital (ROTC) or Return on Invested Capital (ROIC)
is as follows:
ROTC = Net Income/(Owners Equity + Long-Term Debt)
Getting back to the DuPont formula, ROE is a function of profit margins,
asset turnover, and financial leverage. Specifically, the formula looks
like this:
ROE = (PROFIT/SALES) x (SALES/ASSETS) x (ASSETS/EQUITY)
From a simple algebraic point of view, the sales figure is found in both
the numerator and denominator and is thus cancelled out. The same goes
for assets. That leaves profits and top and equity on bottom -- or Net
Income/Equity.
Profitability = PROFIT/SALES
Productivity = SALES/ASSETS
Capital Structure = ASSETS/EQUITY
Looking at each of these three components separately may reveal which
direction the company is headed before the changes show up in ROE --
thus keeping us one step ahead of the public.
Let's start with the first of the three components -- profitability. To
make an educated assumption about which direction a company's profits
are headed, it is important to examine such factors as gross margins and
selling, general, and administrative (SG&A) expenses. Ask yourself
some important questions: Has the firm's product mix improved? Are
margins in line with the industry? Are they expanding or contracting? Is
SG&A increasing or decreasing as a percentage of sales? These types
of questions are a good starting point to assess future profitability.
Next, it is time to look at productivity, or asset turnover. This
measures how well the company is using its assets to generate sales --
and by extension profits. It also tests the quality of the assets
recorded on the books. For example, if a company can generate $10 in
sales with $5 of assets, then it is better than a comparable company in
the same industry that needs $10 worth of assets to generate the same
$10 in sales.
The single purpose of assets is to generate sales and ultimately
profits. Therefore, companies with large fixed asset balances or
goodwill should ultimately generate stronger revenues. A transaction
should only be recorded as an asset if it has some future benefit. If
not, then the transaction should be fully depreciated, amortized or in
some cases written off completely.
Along those same lines, it is important to monitor sales in relation to
receivables. The growth of a company's accounts receivable (A/R) should
generally be in line, rather than above, its sales growth rates. If
receivables are growing at a much faster clip than sales, then this
could be a possible sign of trouble.
Sales should also be measured with respect to inventory. Ideally, a
company should be increasing its inventory turnover ratio, thus
converting inventory to cash at a faster rate. Finally, be sure to watch
for a rising number of employees, which will sometimes show up in
revenue per employee figures.
Finally, we come to capital structure, defined as Assets/Equity. The
most important issue here is the number of shares outstanding. Is it
rising, declining, or static? Be cautious of companies that employ toxic
financing and have problems with shareholder dilution. A company with
excess cash and few internal growth opportunities should return that
money to shareholders in the form of dividends or share buybacks. A
reduction in the outstanding share count will boost the Asset/Equity
ratio. At the end of the day, a stock buyback will enhance per-share
results and entitle all shareholders to a larger slice of the earnings
pie. However, you should be cautious of share buybacks that are executed
when the stock is overvalued, as this is a poor use of capital. You
should also watch out for buybacks that merely cover up excessive
management compensation practices funded with options.
With a closer examination of each of the components that drive ROE,
investors will have a head start in determining which way this
under-utilized metric is headed.
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Important Note: The above article was merely a small excerpt
from a recent issue we sent to subscribers of our premium value investing service --
Margin-of-Safety
Investing. In addition to providing educational guidance, in each issue of that
newsletter editor John
DiStanislao also delivers an in-depth look at a variety of deeply discounted
stocks that should provide investors with a solid margin of safety at
current prices. To receive your copy of our most recent issue of Margin-of-Safety
Investing newsletter, as well as other guidance similar to
this twice per month, you'll need to register for this separate publication.
To learn more, please visit the following link:
https://www.streetauthority.com/subscribe-msi.asp
------------------------
Important Note: The above article
was merely a small excerpt from a recent issue we sent to subscribers of
our premium value investing service -- Margin-of-Safety
Investing. In each issue of that newsletter, editors Nathan
Slaughter and Paul Tracy deliver an in-depth look at a variety of other deeply discounted
stocks that should provide investors with a solid margin of safety at
current prices. To receive your copy of our most recent issue of Margin-of-Safety
Investing, as well as other guidance similar to this twice per
month, you'll need to subscribe to this publication. To learn more,
please visit:
https://www.streetauthority.com/subscribe-msi.asp
Thanks for reading!
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Nathan Slaughter
Editor
Half-Priced Stocks, The ETF Authority
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