Disarmingly simple to calculate, return on equity (ROE) stands as a critical weapon in the investor's arsenal if properly understood for what it is. Return on equity encompasses the three main "levers" by which management can poke and prod the corporation -- profitability, asset management, and financial leverage. By perceiving return on equity as a composite that represents the executive team's ability to balance these three pillars of corporate management, investors can not only get an excellent sense of whether they will receive a decent return on equity but also assess management's ability to get the job done.
Return on equity is calculated by taking a year's worth of earnings and dividing them by the average shareholder's equity for that year. The earnings can be taken directly from the Consolidated Statement of Earnings in the company's last annual filing with the Securities Exchange Commission (SEC), or they can be taken as the sum of the last four quarters worth of earnings. They can also be figured using the average of the last five or ten year's earnings, or they can simply be annualized based on the last quarter's results. (Investors should be careful not to annualize the results of a seasonal business where all of the profit is booked in one or two quarters.)
Shareholder's equity can be found on the balance sheet and is simply the difference between the total assets and total liabilities, as it is assumed that assets without corresponding liabilities are the direct creation of the shareholder's capital that got the business started in the first place. Shareholder's equity is an accounting convention that represents the assets that have actually been generated by the business.
The most common way that investors see shareholder's equity displayed is as a per share value called "book value." Book value is the amount of shareholder's equity per share, or the accounting book value of the business outside of its market value or intrinsic economic value. A business that creates a lot of shareholder equity is a business that is a sound investment, as the original investors in the business will be able to be repaid with the proceeds that come from the business operations. Businesses that generate high returns relative to their shareholder's equity are businesses that pay their shareholders off handsomely, creating substantial assets for each dollar invested. These businesses are more than likely self-funding companies that require no additional debt or equity investments.
One of the quickest ways to gauge whether a company is an asset creator or a cash consumer is to look at the return on equity that it generates. By relating the earnings generated to the shareholder's equity, an investor can quickly see how much cash is created from the existing assets. If the return on equity is 20%, for instance, then twenty cents of assets are created for each dollar that was originally invested. As additional cash investments increase the asset side of the balance sheet, this number ensures that additional dollars invested do not appear to be dollars of return from previous investments.
If return on equity is simply:
One year's earnings
ROE = -------------------------
...then how is it that we can see the profit margin, asset management, and financial leverage through this one calculation? If we expand the equation, unfortunately giving many readers algebra flashbacks, we can start to take into account other variables.
One year's earnings
One year's sales
Because the sales and the assets are both in the numerator and the denominator of the entire equation, they cancel one another out. (For those too stunned by the algebra to fully comprehend the above, you'll have to trust me.) When we break the equation apart in this manner, the three component parts of return on equity come to light. Earnings over sales is profit margin, sales over assets is asset turnover, and assets over equity is the amount of leverage the company has. Each will be discussed on
its own merits. After we have completed this analysis, we will come back to return on equity and how this composite number can be used to evaluate a particular company, as well as exploring its limitations as an analytical tool.
Return on Equity
Above, we examined the concept of return on equity (ROE) and looked at one way to break the number apart into three separate components. Return on equity is one way to measure the return an investor receives on the capital that has been invested in the business. Simply by taking a year's worth of earnings and comparing it to the amount of shareholder's equity on the balance sheet, you get a percentage measure of
how much was returned for each dollar of equity that has been created by the business. Thus ROE can be defined as:
One year's earnings
ROE = ----------------------
However, by manipulating the equation we discovered that ROE
could be redefined the following way:
One year's earnings
One year's sales
One year's sales
This redefinition isolates the three key tools management has at its disposal to affect the returns of the business: pricing, asset management, and financial leverage. Return on equity then becomes a measure not simply of how much of a return the company is generating off of the equity it has created, but also of how successfully management has been in running the corporation.
Profit Margin (Pricing)
Pricing a product or service to create profits and volume is crucial to the success of any corporation. How well would Coca-Cola have fared had it decided that soda should be sold in eight-gallon jugs at $20 a pop? While it might have made quite a bit from this particular packaging because the container cost less as a percentage of the overall price than any other configuration, it is hard to imagine how much in the way of sales volume Coca-Cola would have generated. The average motorist stopping by a convenience store just doesn't have room in the car for an eight-gallon vat of soda. Purchases of the "Coke keg" would have been restricted to home use, parties, and various entertainment establishments.
Pricing has become the realm of "marketing" in the modern corporation. Balancing profitability against volume is the bailiwick of market researchers, promotion gurus, and hard-nosed corporate executives. All the sales volume in the world is meaningless to shareholders if the company cannot manage to turn a profit, though. So pricing a product to be as profitable as possible and generate stable sales growth is the Holy Grail of sales and marketing groups across the business world. The profit margin is one of the easiest ways to assess whether or not this group is meeting the test of the profitability side of the equation.
Profit margin is simply earnings (or profits) divided by sales, both measured over the same time period. Profit margins are the money left over after paying all of the costs of running the business. Managements that increase profit margins are controlling costs either by squeezing efficiencies out of the business or cutting out unprofitable ventures. Although management can cut costs too far -- bleeding out necessary research and development spending, for instance -- for the purposes of analyzing the return on equity generated by a business, a higher profit margin means a higher return on equity.
Profit margins are also an expression of the amount of competition inherent in the business. Competitive industries like grocery stores or discount chains tend to have very low profit margins. This is because it does not take all that much to get into those businesses. Railroads, which operate with the benefit of semi-monopolies on large-scale traffic between points for bulk commodities, tend to have significantly higher profit margins. High profit margins tend to indicate that a company either has a high proprietary good or service, possibly "branded" and therefore able to carry a price premium, or the company is in a business where it has a monopoly or is part of an oligopoly over a particular type of goods or services.
Without some kind of "moat" around the basic business, high profit margins tend to get crunched pretty quickly by new competition. A global brand like Coca-Cola with a massive distribution system to get its product to consumers in a variety of packages makes for one heck of a wall to climb for any new competitor. As Cott Corp. discovered in the early '90s, Coca-Cola could lower its prices to a point where Cott faced significant pain getting its product on store shelves profitably, while Coca-Cola milked
the other elements of its distribution system, like sales to restaurants or sales overseas, to make up for the pain of maintaining market share.
High profit margins rarely come without the kind of entrenched business model Coca-Cola has or the semi-monopoly or oligopoly status a railroad has. A railroad like Norfolk Southern has very limited competition in the regions of the country where it owns the track. A huge, upfront capital investment has purchased the company a relative monopoly in certain geographical regions. However, as we will explore tomorrow, in the case of Norfolk Southern the high profit margin is complemented by a very low rate of asset turnover, limiting the total return on equity. The vast majority of traditional, high-margin businesses are coupled with low asset turnovers, meaning that they can only do a fixed amount of business without incurring additional costs that would constrict profit margins.
Return on Equity
Looking at the profit margins, Norfolk Southern (NYSE: NSC) has a pretty solid business. The company generated 15.7% profit margins over the last four quarters on $4.7 billion in revenue. With the average public company generating profit margins more in the 7% to 8% area and the average company in America in the 2% to 3% range, Norfolk certainly appears to have a nice business going for it. With 15,000 miles of track in 20 Midwestern and Southeastern states, the company competes with only one or two other players in its core rail business, a nice oligopoly. With profit margins such a critical part of return on equity, it should have a substantial edge, right?
Or maybe not. Although profit margins are a crucial element in the return on equity equation, the sales generated for each dollar of assets plays an equally important role. Norfolk Southern has $12.4 billion in assets reported in its last quarter, but it only generates a paltry 38 cents in sales for every dollar of assets it has deployed. By way of comparison, Dell Computer (Nasdaq: DELL) generated $8.7 billion in sales on $3.2 billion of assets over the last year, or $2.71 in sales per dollar of assets employed. Generating more sales on less assets means tying up less of the capital the business
generates in fixed assets. The term "capital-intensive" literally refers to the way some businesses require more capital to function than others. Given these two companies and their assets-to-sales ratio, it is clear that Norfolk Southern is more "capital-intensive" as a business than Dell Computer.
Asset management is probably one of the factors individual investors have the most difficulty using to evaluate a company. Certainly you can compare various asset management ratios for companies within an industry. How can you tell if so much in sales per dollar of total assets is good or not so good for a given company on more than just a relative basis? Looking at asset management in the context of the total return on equity allows the investor to balance a company's asset management ability with its
profit margins and the financial leverage employed in order to discern whether the actual business is great or simply mediocre.
You cannot argue with the kind of profit margins that a railroad like Norfolk Southern generates. However, because the company has to deploy and maintain billions in assets to get those profit margins, the business is not necessarily as exciting as it would otherwise be for the investor. Because Norfolk has to maintain thousands of miles of track and hundreds of trains, it constantly has put new capital into its assets in order to generate revenues. This means that instead of being able to return the cash generated from operations to investors, Norfolk has to reinvest it in its assets in order to stay in business. In spite of this, Norfolk generates plenty of cash flow. If it could actually improve its sales per dollar of assets employed, it could generate tons of cash.
Five quarters ago, Dell Computer realized that one of the ways it could improve shareholder return was to notch up its asset management policies. Specifically, Dell realized that if it could more efficiently manage its inventory of computer components, it could increase the return on equity. As inventory and accounts receivable are Dell's two most significant assets, by minimizing these the company could increase the sales per dollar of total assets employed and therefore increase the basic return on equity of the business. The money that went into inventories to generate a dollar of sales decreased, leaving
Dell with more cash on the balance sheet to distribute to shareholders in the form of stock repurchases. Because Dell has focused on direct sales since it was founded, except for an ill-conceived venture into the indirect channel in the early '90s, the company has always required less working capital than its indirect channel competitors like Compaq Computer. However, Dell only became a full-fledged asset
management story five quarters ago when the stock got pounded because of fears of slowing computer sales in early 1996. As a man who owned an enormous percentage of the company's stock, Chairman Michael Dell knew that without some kind of change Dell would always trade at 11 to 12 times earnings because of the perception that it was in a low-margin, commodity business. The question was how could Dell Computer change the way that people saw its financial model to increase the value of the company?
Dell conceived an ambitious and ingenious plan. It would launch itself pell-mell into the high-margin server business, either improving its own margins or killing those of competitor Compaq Computer. At the same time, it would notch up the number of times it could turn its inventory over each year. Inventory turnover is one of the main asset management measures that investors can easily calculate. Simply by dividing the cost of goods sold over a period by the inventory left at the end of the period, an investor can see how many times a company "turned" its inventory in that period. As a company like Dell increases its inventory turns, it dedicates less assets to generate a dollar of sales, increasing the amount of cash left over to do other things. In Dell's case, the crucial third part of its plan was to use all excess cash flow to repurchase the stock it viewed as undervalued, magnifying the earnings per share growth.
Dell Computer is a clear case of how improved asset management can increase shareholder return. Better asset management eventually shows up in the form of high profit margins, but high profit margins by themselves do not guarantee that shareholders will receive excellent returns. In order to ensure that return on equity is high, investors must look for businesses that have high margins and high asset turnover rates, whether it is sales-to-assets or looking at the inventory turns, the days sales outstanding (or collection period), the payables period, or the turnover in fixed assets. The last variable in the return on equity equation that can affect overall return is financial leverage.
Return on Equity
Say that your profit margin is ebbing and your asset turnover just ain't what it used to be. Knowing that you and your fellow managers at Templar's Treehouses Nasdaq: TREES) are going to be compensated based on the return on equity (ROE) that your company is generating, how can you juice it up? Leverage, mah boy, leverage. A few hundred million dollars in long-term debt to add some working capital to your balance sheet and suddenly asset turnover doesn't appear to be a problem anymore. That capital also lets you expand your operations, pumping out more product at the lower profit margin to increase the raw earnings based on the same shareholder's equity. Leverage is the answer -- heck, for many, leverage is the American way. For the last few days, we have been exploring return on equity as a potential lens through which we can analyze a business. In Part One, we discussed the return on equity equation and how you can actually look at it as three component parts -- profit margin, asset management, and leverage. In Part Two we discussed profit margin and her two sisters, gross margin and operating margin. Since ROE is simply earnings over equity, if you increase the profit margin, you increase earnings. Increasing earnings without increasing equity has a domino-like effect on ROE, increasing that as well. In Part Three there was a discussion of asset management and how increased utilization of business assets can leave more cash for the earnings pile, pumping up return on equity. Today we focus on the third leg of the ROE tripod, namely leverage -- a fancy schmancy word for debt.
A lot of people want you to believe that debt is no good. Most of those people apparently buy their homes with cash. For the rest of the world, debt is much like anything else -- okay in moderation, but overdoing it is not a good idea. As anyone who has ever had a high credit card balance can attest, debt tends to feed on itself, growing to enormous proportions with very little food and watering. When a company takes on debt, it increases the total amount of capital it has at its disposal to finance whatever it is it wanted to finance in the first place. Unlike equity, debt carries a direct cost called "interest" that eats away at a business's profitability. Sure, if you take on $500 million in debt you can suddenly produce 1,200 more widgets a day. However, your profit margins on the extra widgets plummet to 5% from 10% because the interest on the debt costs you 5%, meaning that the additional gain becomes incremental.
The problem with adding leverage to a company's equity as a way to boost ROE is that after a certain point, the actual cost of the debt diminishes profit margins and decreases asset turns. Although certainly there are a number of cases where adding debt makes sense, it is not something that management wants to push as high as possible, unlike profit margins and asset turns. In fact, many perceive earnings generated from debt financing as higher risk than earnings generated from equity financing, particularly if the business is tied to the business cycle in any way, shape or form. Whereas a company that is completely equity financed can normally ride out a downturn, a company with a large proportion of debt financing is unfortunately not quite so well equipped.
Although this flies in the face Modigliani and Miller's Nobel-prize winning M&M theorem that states that the market value of any firm is independent of its capital structure, experientially it appears to me that investors pay less for debt-financed earnings. There are a number of potential explanations for this, the most apparent being that because debt-financing increases the risk that the company would be injured in a cyclical downturn, that risk is discounted into the price investors are willing to pay for future earnings. Put a bit more clearly, because the debt increases the likelihood of bankruptcy, investors are more cautious about the price they will pay for the stock. This alone would be sufficient to keep managers from maximizing leverage to increase the ROE, as it would have the unintended side effect of minimizing the stock price.
There are almost as many ways to assess how much long-term debt a company has than there are mutual funds, but the five most common include the debt-to-assets ratio, the debt-to-equity ratio, the debt-to-total capital ratio, the debt-to-market capitalization ratio, and the debt-to-revenues ratio. All of these ratios simply compare the amount of total liabilities to some other relevant part of the income statement or the balance sheet. In order of the five ratios described, they are total assets, shareholder's equity, shareholder's equity plus long-term debt (total capital), market capitalization, and trailing twelve-month revenues. Although at this point most investors thirst for some general rule such as "debt should not be more than 20% of shareholder's equity," the reality is that general rules are just that, very general. There are all kinds of reasons why a company might want to violate a general rule and little to recommend them, other than the fact that companies that abide by general rules tend to go out of business a little less often.
The best way to analyze debt is to look at the historical trend in debt financing compared to the trend in ROE to see whether or not a company is maintaining its ROE by juicing up the debt. This is one of the key signs of a business model gone askew, as the company replaces rising profit margins and increased asset efficiency with more and more debt to maintain the same level of shareholder return. An important addition to this is to check whether or not the company can afford the debt. Comparing the earnings before interest and taxes (EBIT) to the actual interest expense gives you the times interest earned ratio. You take the EBIT instead of just earnings because interest is not taxable, and if you leave in the interest payment, you have already covered it once.
Earnings before interest and taxes
Times interest earned
This ratio literally tells you how many times a company could have paid the interest on the annual debt burden. Again, although there is nothing really to recommend pronouncing some kind of general rule like "interest should always be covered 10 times," the higher this number, the better the company can handle its interest burden. Should the number start to drift down, unless the company has ready access to cash on the balance sheet or unused borrowing capacity, the risk part of the pricing equation starts to get larger, driving down the stock price. The basic business the company is involved in also has an effect, as companies where earnings are highly cyclical or volatile would want to have higher interest coverage than the average bear.
With a better understanding of profit margin, asset management, and leverage, we will try to put it all together in a way that allows us to use this rubric to analyze a specific company. We also will cover the weaknesses of return on equity, suggesting possible alternatives like return on invested capital (ROIC) or return on operating earnings (ROO) as potential substitutes.
Return on Equity
Understanding what really goes into the deceptively simple number known as return on equity (ROE), the measure becomes a lens through which to analyze a company. Return on equity is a combination of profit margin, asset management and financial leverage. Breaking return on equity into these component parts not only allows the investor to determine what the kind of return on equity is being generated by a company, but also to examine the quality of that return as well as which financial levers management is pulling to create it. In fact, this way of looking at return on equity creates a system of ratios that allows the individual investor to really understand how the basic
business is being managed.
USA Detergents (Nasdaq: USAD) represents an excellent example of how analyzing the components of the return on equity equation would have led an investor to radically different conclusions than by simply looking at the ROE number by itself. In 1996, USA Detergents generated a return on equity of 21.5%. Although strikingly high for a detergent company, it was down from 34.6% in 1995 and 72.6% in 1994. Looking at the10-K, an investor would have been left to answer the riddle of why the return on equity had been declining so rapidly over the past twelve months and what it foretold for the company's stock.
The first part of the ROE analysis is to look at the profit margin. USA Detergents had sales of $68.7 million in 1994, $104.9 million in 1995, and $174.0 million in 1996. The company earned profits of $4.3 million in 1994, $7.0 million in 1995, and $8.9 million in 1996. As profit margin is simply earnings divided by revenues, this means that the profit margin over that three-year period went from 6.3% in 1994 to 6.7% in 1995 and finally dropped to 5.1% in 1996. The first impression is that USA Detergents is not a very high margin business. The company makes commodity, value-priced laundry detergents under brand names with questionable staying power, an impression confirmed by the margin. We can determine initially that the high returns on equity certainly are not coming from high profit margins.
Although the drop in ROE could from 1994 to 1995 did not come as a result of falling margins, in the slip from 1995 to 1996 profit margin certainly contributed and is worth exploring further. To do this, we would next look at the company's operating margin, a ratio of the operating earnings to the revenues. Operating earnings tell you how the company's operations were doing, outside of the effect of changes in tax liability or interest payments. For USA Detergents, operating earnings in 1995 were $9.7 million and $15.7 million in 1996, meaning that operating margins increased from 9.3% to 9.9% over the period. A quick look at the tax rate identifies the culprit, as from 1995 to 1996 the tax rate jumped from 23% to 40%, taking a nice whack off the top of the profit margins. Otherwise, operating earnings actually improved.
Since profit margin or any other ratios from the income statement do not really explain the shortfall, we next move to the left side of the balance sheet, or the assets. Asset turns is simply sales over total assets. As USA Detergents had $24.5 million in assets in 1994, $40.6 million in assets in 1995, and $98.9 million in assets in 1996, we can immediately see that assets were growing faster than sales. Asset turnover in 1994 was 2.8 times, in 1995 was 2.6 times, and in 1996 plummeted to only 1.8 times. Looking deeper into the asset side of the balance sheet, the huge build up in inventories and accounts receivable seem to be the cause. Inventory turns (cost of goods sold divided by average inventory over the year) dropped from 8.7 to only 4.3, given that the company had $8.5 million in inventories in 1995 and $27.0 million in 1996. Days sales outstanding (365 divided by sales over accounts receivable) also rose from 53 to 59.
Both lower inventory turns and higher days sales outstanding meant that although the company was booking plenty of sales, it was building up cash-sucking inventories faster, and it was not as efficient at collecting money from its sales. A classic problem with small companies, USA Detergents appeared to be literally "growing" broke as working capital needs consumed more and more of its profits. Faced with
mounting working capital needs and pretty flat income from operations, management at USA Detergents was left with only one financial lever to try to generate more earnings out of its basic business --turning up the financial leverage.
Turning to the right side of the balance sheet, or liabilities, we see that long-term debt increased from $1.8 million in 1995 to $30.8 million 1996. With stockholder's equity of $20.3 million in 1995 and $41.3 million in 1996, this meant that the debt-to-equity ratio jumped from 8.9% in 1995 to 74.6% in 1996, a pretty massive leap. Debt-to-total equity (debt plus equity) climbed from 8.1% to 37.3%, a sizable leap but not necessarily the same magnitude. Any one of the of half-a-hundred other ways to compare debt to some other part of the company's balance sheet shows the same conclusion -- debt as a portion of equity increased dramatically in 1996 as the company struggled to meet working capital needs and maintain its earnings.
Although in 1996 the times interest covered (earnings before interest and taxes divided by interest expense) was still 18 times given that interest expense was $0.9 million, the fact that asset management was deteriorating and causing the company to become increasingly debt financed increased the risk. Most investors know that shortly after the year-end statements were reported, USA Detergents' stock price fell from the mid-$20s to the current perch at $12 and change when the company missed earnings expectations.
By looking at trends in return on equity and analyzing the components, the investor is forced to not only examine the much overlooked Statement of Operations, or the Income Statement, but also to balance this against the left and right sides of the Balance Sheet.
Interpreting The Return On Equity Ratio
A high Return On Equity value may be the result of a high Return On Assets, or due to debt (leverage). Return On Equity is often used to determine if a company consumes cash or creates assets. For example: If a small company generates $300,000 of Net Income, and Shareholder's Equity is $1,000,000, then ROE is 30%.
In this example, you may imply that three dollars ($3.00) of new assets is generated for every ten dollars ($10.00) invested. The question, then, is how did this small company do so well?
You need to evaluate the rest of the balance sheet.
If our small company owes very little debt, then it is reasonable to assume that our managers are earning high profit margins or turning assets effectively. This would be shown by a relatively high value for Return On Assets.
If, on the other hand, the company is deeply in debt, then a high ROE is likely due to leverage. The Return On Assets value will bear this out. In this example, while ROE is high, ROA would be relatively low.
Return On Equity can also help you evaluate trends in a business. And ROE can also be used to compare the performance between companies in the same industry.
One word of caution when using Return On Equity. Financial statements show assets at their book value, which is the purchase price minus depreciation. They do not show replacement costs. A business with older assets should show higher rates of Return On Equity than a business with newer assets.