Myths and Misdemeanors

It’s one thing to generate profits, it’s another to do so efficiently. ROE, or return-on-equity, measures how efficiently a company uses its earnings, to grow earnings.

The Street helpfully defines ROE as a company’s annual net income (less non-recurring items) divided by its shareholder equity, or book value, (total assets less total liabilities), but this is a deceivingly simple definition. Understanding the more complex formula will help highlight its limitations.

ROE is actually the product of three ratios: profit margin (earnings/revenues), asset turnover (revenues/assets), and leverage (assets/equity). An increase in any of the three ratios – all other things being equal – produces a higher ROE. For instance, a company can increase profit margin by cutting costs, or it can increase asset turnover by introducing new products that can be manufactured with current equipment. Both of these will also increase ROE. That’s fine, but eventually we want to see an increase in earnings that’s the result of growing revenue; not just constantly reigning in expenses.

Likewise, a reduction in any of the denominators of any of the ratios that comprise ROE will also artificially boost this efficiency ratio. A write-down, for example, which shows up on an income statement as an expense, dampens earnings (the numerator) only in the year the write-down is taken, but it has a prolonged dampening effect on shareholder equity in subsequent years, which means in those years, ROE may display mathematical improvement in the absence of actual operational improvement.

Return-on-Equity: Increasing Leverage

A company can also increase ROE by increasing leverage, and it can increase leverage by borrowing, which, of course, increases the company’s debt. This may be ROE’s primary weakness: Its failure to recognize an increase in debt beyond acceptable levels. Of course, any increase in debt will decrease shareholder equity. As equity (the denominator) approaches one, ROE is nudged deceptively higher. Taken to the extreme, it can push equity to zero, making ROE impossible to calculate.

When screening for stocks boasting high ROE, it’s crucial to include a debt-to-equity filter. An especially rigorous screen will also include a liquidity filter – the so-called liquidity ratio, for instance, a.k.a. the current ratio or cash asset ratio. It’s calculated by dividing current assets by current liabilities. The higher the number (with 2.0 as the acceptable minimum), the more liquid the company, in other words, the more able the company is to pay its short-term debt.

ROE has other limitations, too. Because it includes earnings in its calculation, it’s intrinsically susceptible to manipulation. If earnings figures have been pumped up, profit margin will look artificially high, which, in turn, artificially inflates ROE. In addition (or subtraction?), ROE fails to account for intellectual property, like patents and trademarks, which means that shareholder equity may be undervalued, which also results in a misleading ROE.

Return-on-Equity: Why Bother?

Well, that’s a helluva list of caveats.

Why bother with ROE at all? While ROE can be deceptive, it can also indicate how effective management is at wringing profits out of its operations. Companies that do well at this, tend to have a distinct advantage over their competitors, which tends to translate into superior price performance. The most effective way to use ROE is in combination with other metrics and as a comparative measure of efficiency within industries.

So long as we’re armed with all its potential pitfalls, we can regard a high ROE as an indication of industry leadership and potential undervaluation relative to a company’s own growth potential and that of its peers.

Regards,

Carl Waynberg
for The Daily Reckoning
December 23, 2004

—————-

The markets are slowing down, as we approach the holidays.

Here at the Daily Reckoning, at our Christmas headquarters in rural France, we too are turning our eyes from the public spectacle in the newspaper headlines, to our own private lives.

By day, we bustle in preparation…and then, when all the bustle has gone out of us, we gather in front of the fire for another chapter of Dickens’ A Christmas Carol. We have no television. But TV too, like expensive stocks, aggressive war, and demanding mistresses is one of those things best enjoyed by abstinence.

Instead, Elizabeth reads aloud. And, in our imaginations, we hear the rattle of Jacob Marley’s “chains forged in life,” and the sweet sound of the voice of Christmas Past reminding Ebenezer of what might have been.

There might have been a collapse of the Dow yesterday. Instead, stocks went up. Someone is very wrong. So far, it seems to be us. We believe stocks are a trap for the unwary. We are betting on a single, simple Trade of the Decade: sell stocks, buy gold. We proposed the trade nearly five years ago. So far, it has rewarded us nicely. Stocks have gone down and up…coming to rest not far from where they were five years ago. But gold has gone up 60%.

Stocks – at least the Dow – has refused to go down as we expected it would. Yesterday, the Transportation Index actually hit a new all-time high. Imagine that. We guess it is because so many goods from Asia are being hauled over so many miles to get to their end-users. And we doubt that it is a good sign. It merely shows how willing Americans have become to spend money they don’t have – forging chains of debt that they will drag around for many, many years.

We hear the smithies hammering all over the country. Everywhere, everyone is convinced that nothing will go wrong…nothing will interfere with Americans’ fabulous dreams of wealth forever. And so, they buy another SUV…a new plasma TV…an iPod…a new house even!…and happily they bang on their links…adding to the nation’s iron of debt…half a trillion dollars more per year, more or less.

Clang. Clang.

More news, from our friends at The Rude Awakening:

—————

Eric Fry, reporting from Wall Street…

“‘Your box of money is very impressive, Henry,’ your editor remarked. ‘But I don’t need any convincing about the long-term value of gold…So let’s take a shorter time horizon. How does gold look to you in 2005?'”

—————

Bill Bonner, with more views from Poitou…

*** From Fleet Street editor, Chris Mayer:

“The collapse of the stock market bubble cut the value of many pension fund investments and left company-funded programs scrambling to meet the demands of an aging workforce…

“Retirement as we know it will become a thing of the past. People will work until the day they die. We are likely to see ‘retired lawyers’ flipping burgers at McDonald’s… and former airline pilots chartering ‘kiddie rides’ at traveling carnivals.”

Sound unlikely? Pension companies going belly-up is just one of the predictions Mr. Mayer has made for the coming year…

*** Ahh…Christmas in the country…

“Gosh, when I told people I was going to stay in a French chateau for Christmas, they were all so envious,” said our daughter-in-law. “But they imagined that it would be so luxurious. It’s very nice, but it is not exactly luxurious. In fact, I don’t know if I’ve ever seen so many children working so hard. “

“Ha!” said Jules. “Are you kidding? It’s pure misery. I wanted to stay in Paris. Out here, it’s nothing but work. We get up in the morning and have to make fires in the fireplaces. Then, Dad puts us to work – either building stone walls or painting something. I worked all day yesterday on that library….and there’s still a lot to do. And then we had to go out and find a Christmas tree, cut it down and drag it all the way to the house…”

“Yes, and you seem to have dragged it through the mud,” said his mother.

“Oh, stop complaining. Work, work, work…that’s all we do around here. And now we have to decorate the house…and we have to work all day for the party you’re having this evening. And we don’t have a TV…and there’s nothing to do. And the place is always cold and dark. It’s no wonder we always get sick when we come out here…”

*** We went to choir rehearsal last night. It is not a very serious choir – just a group of eight or nine aficionados who warm up once or twice a year in order to belly-out a good tune. The amazing thing is that people always seem to find something to argue about – no matter how trivial the stakes.

“I used the microphone last year,” said a soprano, “and people complained that I sang too loud. I’m not doing that again.”

“But you have to use the microphone,” said a tenor, “or people won’t be able to hear you.” “Oh no, it will be a cold day in Hell before I use a microphone.”

“You are so selfish!” said an alto.

“Aren’t we rehearsing for Christmas?” asked an basso-profundo.