Trend Analysis of ROE

Trend Analysis of ROE

       

It’s important to look at the profitability of a company in terms of what the shareholders have invested. That’s what Return on Equity does. It’s really made up of three other ratios.

Net Margin (net income / revenues) multiplied by asset turnover (revenue / assets) multiplied by leverage (assets / equity)

If you’re a math guy you notice that both revenues and assets cancel each other out (I’ve got grade eleven math myself but don’t tell anyone)

This is the DuPont model of ROE. It shows you where a company’s profits are coming from. It could be from margins, or is the company more efficient at turning over its assets? Or has the company taken on debt? In other words ROE measures not only profitability but efficiency of management as well as leverage. If the company has shown consistently high rates of ROE (over 13 percent) over the years, it should translate into strong earnings per share and a rising stock price. Keep in mind that banks and financial companies due to their financial structure will have overly high leverage ratios thus inflating their ROE’s so you should insist on a higher ROE from them than non-banking firms.

To really gain insight into a company’s performance you should track ROE over a period of a few years. There is no other way of telling whether a company’s performance is improving, remaining the same or, or deteriorating. Trend analysis will highlight the trends over time so the investor can make more informed investment decisions. Any company that can maintain a high ROE over time must be redeploying their cash productively or else the ROE would drop. In other words the management of these companies are good capital allocaters. Remember its not enough for management to be good operators of their business, they must be able to take their excess profits and put them back into the company to grow their business. High margins are a good sign, if they are slowly rising over time, even better. Keep an eye on the leverage ratio. If it is too high management may be trying goose returns by overly relying on use of debt. Higher turnover ratios mean the company is using its assets more efficiently.

By tracking these figures over the span of a few years the investor will be quickly able to separate the wheat from the chaff. And of course once you gain more experience working with these metrics, your intuitive side (right brain) will start playing a bigger role in the evaluation process...have fun.

Financial Metrics and Ratios

Financial Metrics and Ratios

I’m a growth investor with a value bent so I want to buy growth but I don’t want to pay for it. That being said I want to focus on the metrics of a company that shows me it’s growing and becoming a larger more profitable enterprise. As always I try to keep things simple. I prefer to look at the operating metrics of a company first and let things fall into place after that. The following is a list of metrics that I like to see growing over time.

Revenues

Operating Income or (EBIT, earnings before interest and taxes)

Operating Margin                               (gross profit - operating expenses)

Operating Cash Flow

Book Value per Share                          

Free Cash Flow                                     (operating cash flow – capital expenditures)

Free Cash Flow per Share

Return on Invested Capital (ROIC)

Return on Equity (ROE, the Dupont formula which breaks ROE down into three components…

1)      Net Margin                    (net income / sales)

2)      Asset Turnover              (sales / assets)

3)      Financial Leverage        (assets / equity)

I also check to see if the company has retained earnings on its Balance Sheet. This allows the company to re-invest in their business for future growth. As I prefer smaller to mid cap companies I’m looking for scalable growth. I don’t want them growing too fast although that can be a good opportunity to get into a great situation early but it also increases the risk of the company getting ahead of itself and blowing up so you have to be careful.

Don’t get hung up on the precision of the numbers, they are only there to put you in the ballpark. Remember they are based on a lot estimates and assumptions on the Income Statement and the Balance Sheet.  The numbers should be your servant not your master. Following the trend in metrics like operating income, operating margin, operating cash flow, book value per share and return on invested capital can tell you a lot about the growth prospects of a company. (cannibalizing my own stuff already)

Management is especially important in a smaller company. Not only do they have to grow the revenues of the business, they also have to control the costs and risks of growing those revenues. They are responsible for allocating any surplus capital in order to expand the business of the company as well as negotiating financing needs with third party entities.So management is important. You might want to read about the CEO, CFO and maybe about some of the directors on the board as well. Now if I could only follow my own advice.

I guess that’s all for now. This was only meant to be a quick overview of a rather large subject. I’ll post more about financial ratios in the future. The learning process never really stops once you get your nose into this stuff. But if you like it, its fun and in the end empowering as you are developing a skill set nobody can ever take away you from.

ROIC is the after tax operating income relative to the capital invested in the firm, where capital is defined as the sum of the book value of debt and equity, net of cash and marketable securities.

ROE relates profits to the equity investor (net profit after taxes and interest expenses) to the book value of the equity investment.

These are profitability ratios which show how much value management is adding back to the company over time. Probably, two of the most useful ratios in all of investing.

The growth of book value or equity per share is a key item as it shows that the value of the investment dollar of the equity holder is increasing and therefore creating additional wealth over time.

Books and Resources

The Edgar Online Guide to Decoding Financial Statements by Tom Taulli

Financial Intelligence by Karen Berman and Joe Knight