2B or Not 2B: Return on Equity CLASSES TO GO! 2B or Not 2B: Return on Equity Ronald Bruyn, MBA BIVAB Associate Director

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Today we’ll learn: What is Return On Equity (ROE)? What are some of the problems in interpreting Return on Equity? How can Return on Equity be distorted on the SSG? Why should we be careful in applying ROE to our judgments?

What is Return on Equity (ROE)? A measure of management’s efficiency. It is a measure of management’s efficiency. It is probably the most widely-used method by analysts of how well a company is performing for shareholders. It is probably the term that individual shareholders understand the least.

Equity (EPS / book value) Return on Equity (EPS / book value) Return on Equity appears as Line 2B on the SSG. Notice that the definition of % Earned on Equity on the SSG is EPS divided by book value. Sometimes this figure will not match in Value Line and OPS, because Value Line normalizes the data, especially EPS. 5.6%

Net income after taxes/shareholders equity x 100 = 5.8% ROE Analysts (but not Value Line) define Return on Equity as net income (after taxes) divided by shareholder’s equity However, Return on Equity is generally defined by analysts as net income after taxes divided by shareholder’s equity. ROE is figured by dividing net income by shareholder’s equity. In actuality the figures derived from EPS/book value and net income/equity are very close. I compared the two ratios on a number of companies and discovered that they were within tents of a percentage point of each other. (examples: Armor Holdings AH EPS/book value: 5.6%; net [profit divided by equity =5.7% Aviall AVL EPS/book value = 10.5%; net income divided by equity = 10.2% Boeing BA EPS divided by book value = 9.8%; net income divided by equity = 9.9% Net income after taxes/shareholders equity x 100 = 5.8% ROE

EPS/Book Value .59 / (9.78+10.45) x 100= 5.8% 2 EPS/Book Value .59/10.45 x 100 = 5.6% ROE The Value Line Calculation: EPS/Book Value .59 / (9.78+10.45) x 100= 5.8% 2

BetterInvesting and analysts: slightly different ways of calculating ROE, BUT the results are similar. NAIC and the analysts have slightly different ways of calculating ROE, but their results are similar.

ROE on Value Line EPS/Book Value .59/(9.78+10.45)=5.8% 2 Return on Shr. Equity 5.8% EPS/Book Value .59/(9.78+10.45)=5.8% 2

What is Book Value? Actual value of the assets of a business. Another term for shareholder equity What is Book Value? It is the actual value of the assets of a business. Book value is the same as equity or shareholder equity.

Book Value Total assets minus total liabilities minus intangible assets Looks backwards Not accurate in some industries Affected by leases Affected by intangible assets Book value represents the net amount of company dollars after subtracting total liabilities from total assets. It includes total assets minus intangible assets (patents, trademarked names, goodwill, etc.) and liabilities This is how much the company would have left over in assets if it went out of business immediately. Book value is a backward looking number, often figured only once a year and available in the company’s annual report. It is vulnerable to being overtaken by new debts or other liabilities; in fact, some of the numbers within it may be older than one year – for example, property may be revalued only once every five years. Some business will never have a high book value due to the nature of the business. Internet start-ups, recruitment firms and companies where value is in client relationships not land or equipment are examples. They are vulnerable to unexpected moves of key personnel. Valuing some assets can be uncertain; for instance leasing equipment and stores affects Total assets. Intangible assets such as Goodwill also is subject to an auditors’ interpretation

Where do we find Book Value? Book Value can be found on Value Line and on the annual data sheet for Toolkit. Remember, these two figures may not be the same; OPS is based on Standard and Poor’s and Value Line is normalized. Be consistent in comparing these figures. Value Line calculates the book value per share for every company, and also indicates in a footnote how much of a company's book value is based on intangibles. Conservative investors may want to deduct these amounts when they are analyzing the financial strength of a company. Book Value 10.45

Reminder: Value Line uses ROE = EPS divided by AVERAGE book value per share (an average of beginning book value and ending book value) A reminder: Analysts (including Value Line) use: EPS divided by Average book value per share.

BetterInvesting uses: EPS divided by ENDING book value per share NAIC uses: EPS divided by Ending book value per share, But the results are similar!

Profitability Asset Turns Leverage Return on Equity Profitability Asset Turns Leverage Return on Equity is actually divided into 3 parts: profitability, asset turns (or turnover) and leverage.

What is profitability? Section 2A - profit before taxes Section 2B - after taxes, not before taxes (as in 2A). What is profitability? Section 2A Pre-tax profit on Sales measures profitability - how effective management is at managing costs. ROE looks at profitability after taxes, not before taxes (as in 2A).

Is it good to increase profitability? YES!

What are asset turns? The amount of inventory the company can sell relative to its asset base or How often a company turns over its assets or inventory in a year. This is industry specific, just like 2A

Asset turnover is industry specific! The amount of inventory the company can sell relative to its asset base or How often a company turns over its assets or inventory in a year. Asset turnover is industry specific! Asset turnover is industry specific! Let’s use an example: Ford has a low asset turnover. Each vehicle turns over (leaves inventory) more slowly than the items sold in a store such as Bed Bath and Beyond; In addition plants a equipment have a low turnover rate. Automobile manufacturers will have a low asset turn ratio. Compare companies to other companies in the same industry! A car company can increase asset turnover by increasing sales. A company like Bed, bath and Beyond will have a high rate of asset turns. The retail industry has a high turnover rate of products on their shelves. Bed, Bath and Beyond cannot be compared to Ford. Where do we find this information? In the Annual report. Total asset turnover = sales divided by total assets Not unusual for TAT to be less than 1, especially if a firm has a large amount of fixed assets. Ford has a turnover ratio of .5.

Is it good to increase asset turns? Yes! (but difficult)

Leverage is debt. What is leverage? The higher the debt the higher the leverage. The degree to which an investor or business is utilizing borrowed money. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Leverage is not always bad, however; it can increase the shareholders' return on their investment and often there are tax advantages associated with borrowing. also called financial leverage.

It it good to increase leverage? MAYBE!! There are sometimes tax advantages that increase shareholders’ return on investment.

Debt can help a company expand BUT Too much debt can be a problem!

Debt can help a company grow Too much debt can destroy an unstable company Debt is often needed to help a company grow, but too much debt can destroy an unstable company. If sales turn down, the company may not be able to meet its debt and interest payments.

Let’s relate profitability, asset turns and leverage to our definition of Return on Equity.

ROE = Profitability x Asset Turns x Leverage Profitability = Income divided by Sales Asset Turns = Sales divided by Assets Leverage = Assets divided by Equity

Profitability x Asset Turns x Leverage = ROE Now for some math… Income Sales Assets Sales Assets Equity ROE Or Profitability x Asset Turns x Leverage = ROE Here’s how the factors in the equation break down or “expand”

Notice that some of the items cancel out. Income Sales Assets Sales Assets Equity This leaves us with our original equation: Income / equity Income divided by equity = ROE ROE Notice that some of the items cancel, leaving us with the analyst’s ratio or Income/equity.

Are all three terms equal? Increasing profitability is good. Increasing asset turns is good. But.. Is increasing debt necessarily good?

With this in mind, let’s go back to our Return on Equity formula With this in mind, let’s go back to our Return on Equity formula. Let’s see what happens if we increase each item separately. With this in mind, let’s go back to our Return on Equity formula. Let’s see what happens if we increase each item separately.

Increasing profitability increases ROE Profitability x Asset turns x Leverage Let’s assume: Profitability = 2 Asset Turns = 2 Leverage =2 2 x 2 x 2 = 8 ROE Let’s increase profitability to 4 4 x 2 x 2 = 16 Profitability x Asset turns x Leverage Let’s assume: Profitability = 2 Asset Turns = 2 Leverage =2 2 x 2 x 2 = 8 Let’s increase profitability to 4 4 x 2 x 2 = 16 Increasing profitability increases ROE

Increasing Asset Turns Increases ROE Profitability x Asset turns x Leverage Let’s assume: Profitability = 2 Asset Turns = 2 Leverage =2 2 x 2 x 2 = 8 ROE Let’s increase Asset Turns to 4 2 x 4 x 2 = 16 Profitability x Asset turns x Leverage Let’s assume: Profitability = 2 Asset Turns = 2 Leverage =2 2 x 2 x 2 = 8 Let’s increase profitability to 4 4 x 2 x 2 = 16 Increasing Asset Turns Increases ROE

Increasing Leverage (debt) Increases ROE Profitability x Asset turns x Leverage Let’s assume: Profitability = 2 Asset Turns = 2 Leverage =2 2 x 2 x 2 = 8 ROE Let’s increase Leverage (debt) to 4 2 x 2 x 4= 16 Increasing Leverage (debt) Increases ROE Profitability x Asset turns x Leverage Let’s assume: Profitability = 2 Asset Turns = 2 Leverage =2 2 x 2 x 2 = 8 Let’s increase profitability to 4 4 x 2 x 2 = 16

All three increases produced the same result but is each increase of the same quality? Profitability increases are good Asset turn increases are good Debt increases may not be good All three increases produced the same result but is each increase of the same quality? Profitability increases are good. Asset Turn increases are good. Debt increases are often not good for the company.

Return on Equity can be complicated and deceptive! CAUTION!! Return on Equity can be complicated and deceptive!

Up is not always good and down is not always bad! Increasing debt may cause rising Return on Equity. Decreasing debt may cause falling Return on Equity. You may be able to rely on ROE if there is NO debt. In essence you are then looking on Return on Assets, just like Warren Buffet.

Can we spot which factor is causing the change in ROE? Maybe…

Other factors can also influence Return on Equity… Acquisitions and mergers. Expensing costs for research and development under the new accounting rules. Other factors can also influence Return on Equity… It can be greatly affected by acquisitions and mergers. It can be affected by expensing costs for research and development under the new accounting rules.

When can we safely use ROE? When a company consistently carries no debt When we’re willing to do the research When can we safely use Return on Equity? When a company carries no long-term debt, you can assume that increasing Return on Equity is due to increasing asset turns or increasing profitability. If debt is discounted, you are effectively dealing with Return on Assets – the Warren Buffet approach.

Here’s the bad news! 2B is complicated. 2B is not reliable as a simple answer to efficiency. Up may not always be good and down is not always bad. This part of the SSG is much more complicated than it appears at first. It also is not reliable as an immediate answer to questions about efficiency. Up may not always be good and down is not always bad.

Today we learned: Two definitions for Return on Equity, which produced similar results. Some of the problems in interpreting Return on Equity How Return on Equity can be distorted on the SSG Why we should be careful in applying ROE to our judgments

Sources NAIC Stock Selection Handbook by Bonnie Biafore Return on Equity Motley Fool Working with Financial Statements www.usoiuxfalls.edu

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