Having talked briefly about my thoughts on dividends previously, I turn my attention at this point to what I consider one of the more important aspects of investment analysis:  Return on Equity.   Return on Equity is probably one of the easiest things to measure and probably the hardest to really understand.  It is defined by the following formula:

             ROE = (Earnings)/(Shareholders Equity)

 So what exactly does this measure?  Simple, it measures what kind of earnings power a company generates on capital employed by the business.  In short, if I were to walk up to a company and hand them a dollar to invest in their operations what kind of return can I expect them to generate from it?  The issue of whether they will distribute the respective earnings as dividends or retain them and redeploy them into operations is irrelevant to the equation (though not to the investor at the end of the day). 

So what does a high ROE value mean?  It means that a company can generate excessive returns on capital deployed into the company.  Let’s look at two companies; Company A and Company B with the following characteristics:

	Average ROE (10 Years)	Book Value (Equity)
Company A	40%	$1,000,000
Company B	20%	$2,000,000

 Let’s assume that all other aspects of the company are identical.  Let’s further assume that the two companies are started at the same time and compete head to head.  Finally, let’s assume that the current managements of both companies decide they are way more fiscally savvy than you so they retain all their dividends.  Company B has a higher value at the outset and is worth more to the liquidation market.  However, after year 1 both companies have earned $400,000 so they appear to be neck and neck in competition from all respective measures.  Indeed, Company B has a higher asset value so you can probably assume that it would trade a higher price than Company A. 

But what happens over the long term? 

If we assume that the averages hold true over the next decade, at the end of 5 years you would have a much different story.

	Company A			Company B
Year	Book Value	Earnings		Book Value	Earnings
0	$1,000,000.00	$ 400,000.00		$2,000,000.00	$400,000.00
1	$1,400,000.00	$ 560,000.00		$2,400,000.00	$480,000.00
2	$1,960,000.00	$ 784,000.00		$2,880,000.00	$576,000.00
3	$2,744,000.00	$1,097,600.00		$3,456,000.00	$691,200.00
4	$3,841,600.00	$1,536,640.00		$4,147,200.00	$829,440.00
5	$5,378,240.00	$2,151,296.00		$4,976,640.00	$995,328.00

 Not only has Company A made up for the smaller startup value but due to the magic of compounding the lead that Company A now has is widening at an ever faster rate.  Obviously the ROE values I have used are high but I did it intentionally as a useful illustration.  ROE is a shareholders equivalent of a bond coupon rate.  As long as the gap in ROE persists and is expected to continue to persist, Company A should probably be valued at a higher value than Company B.  Not only that, as long as the ROE exceeds the expected rate of return of other investment opportunities earnings should be redeployed back into the company.

Here is another added benefit of companies with high ROE.  Companies with high ROE operate on a smaller asset base than those that operate with a lower ROE.  It’s a simple fact that you get more “bang for your buck.”  Basically, you will generate higher returns off of a smaller asset base.  In periods of inflation these companies thrive.  Why?  It goes back to the smaller asset base.  

A quick accounting lesson:  Companies buy things like property, plants, and equipment to provide services and products to their customers.  The minute any of these things are purchased they are immediately recorded on the books at the cost of purchase.  You buy a car for $10,000 then somewhere on the balance sheet under “assets” there will be an entry labeled car (this sort of stuff is usually listed under “Property, Plant, and Equipment” for public companies) for $10,000.  Now as you start using this car you immediately start depreciating it.  Let’s say the useful life of the car to the company is 5 years.  Logically you would depreciate the car $2000/year.  So at the end of the year 5 the car has $0.00 in value on the books to reflect the fact that it now has $0.00 of real world value to the company.  At this point the company trades in the car and buys a new one, recording the price of the new car, whatever it may be.

In the interim 5 years the price of cars has probably risen a little.  In an economy that is inflating at 5%/year the same car would cost you about $10,200. 

Of course this makes your assets look a lot more impressive since you now have a $10,200 asset where you used to have a $10,000 asset.  But really you still have essentially the same car.

In companies with larger book value a high inflation environment is a killer because it is simultaneously making their future returns worth less and making their cost of replacing their source of income (their working assets) more expensive. 

Companies with higher ROE can distribute earnings to shareholders in times like these and let them convert the cash into assets if they so choose or better yet, redeploy the capital and stay ahead of the inflation.  As long as the ROE exceeds inflation than the shareholders won’t lose value.

Unfortunately, few companies have the sort of franchise which enables them to consistently redeploy capital at the same rate of return.   Still, I think that understanding ROE is a great starting point for investment analysis because it forces you to think about how funds flow from the balance sheet out to the income statement and then back again. 

Great you say, let’s go run a screen on the entire list of public companies that exist and find the ones that generate high ROEs and put some money in all the ones over, say, 15%.  That’s way better than the stock markets returns historically.  I can’t believe no one has thought of this yet!

Well, it’s not as easy as it sounds.  Capital has a certain amount of weight to it.  As your asset base grows, the amount of money you need to generate solid returns increases as well.  It’s fairly easy to earn 20% returns on $100.  It’s another matter entirely to do it on $10 billion.  The number of opportunities shrinks as your asset base grows.  So companies that were earning 20% for the last 20 years have probably saturated the market for whatever product they are selling and can’t generate the kinds of returns they need.  They then usually go off and start acquiring worse performing businesses under the auspice of finding another “golden goose.”  When the goose turns out to be a lame duck they then make some excuse about changing market conditions or something.  Either way the shareholder is left in the cold and the ROEs of the past are left in the past.

Plus, managements have figured out ways for the underlying business economics to stay the same while the ROE figure changes due to their poking and prodding. 

How?

Well, companies have a number of ways to boost their Return on Equity or simply keep it from falling.  Let’s do some basic algebra on our ROE equation: 

ROE = (Earnings/Shareholders Equity)

ROE = (Earnings)/(Sales) x (Sales)/(Assets) x  (Assets)/(Shareholders Equity)

ROE = (Profit Margin) x (Asset Turnover) x (Leverage)

So, given this we’ve got three basic ways to increase our ROE figure.  We can simply increase any of the three components of the equation.

1. We can boost profit margins.  (make more money on each product or service)
2. We can boost our asset turnover.  (make more products or services with the assets we have)
3. We can boost our leverage.  (reduce our shareholders equity in relation to our assets) 

Basically what this boils down to is we can boost the earnings side of the ROE equation or reduce the equity side of it.  Now the first two items in our list above are affected by all those snazzy “streamlining” initiatives that companies undertake when times get tough. 

You can boost profit margins by laying off excess workers, reducing the redundancy of operational systems, and just generally trimming the fat.  All of these are good things from an operations standpoint.  

You can boost asset turnover by keeping your inventory levels low, reducing the excess cash you have laying around or writing down a bunch of assets on the books (“It is unfortunate to report at this years shareholder meeting that the corporate jet that we thought was worth $2 million has been appraised at $1.2 million.  This asset impairment pains us all deeply.  Moving on to happier news we noticed a small uptick in asset turnover, let’s give our management team a round of applause.”)

But the real killer way to boost ROE is leverage.  You can take on so much debt that your equity just shrinks away to nothing.  And then, when your company goes into default and files Chapter 11, the mutual fund managers who invested in your company can point to your high ROEs and say, “how the hell were we supposed to suspect that the stock was overpriced when it was generating earnings out the wazoo and had ROE figures in the stratosphere?” 

And everyone will understand that the money managers were hoodwinked.  Thus, they will save their jobs, and you will feel great sympathy for them.  And they will collect their management fees and you will collect a tax write off from your losses.

Like everything else, ROE is just a starting point to analysis.  Look at what kind of returns a company is generating with its shareholders’ capital and how it is doing it and you will be well on your way to understanding the company’s operations.

This Page was last update: 3/2/2004; 10:12:00 AM
Copyright 2004 Edward Goodwin
Theme Design by Bryan Bell