CLASSES TO GO!
2B or Not 2B: Return on Equity
Ronald Bruyn, MBA
BIVAB Associate Director
BETTERINVESTING NATIONAL CONVENTION
Disclaimer
•
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•
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BETTERINVESTING NATIONAL CONVENTION
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?
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What is Return on
Equity (ROE)?
A measure of
management’s efficiency.
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Return on
Equity (EPS / book value)
5.6%
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Analysts (but not Value
Line) define Return on
Equity as net income (after
taxes) divided by
shareholder’s equity
Net income after
taxes/shareholders equity x 100
= 5.8% ROE
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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
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BetterInvesting and analysts:
slightly different ways of
calculating ROE,
BUT
the results are similar.
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ROE on Value Line
Return on
Shr. Equity 5.8%
EPS/Book Value .59/(9.78+10.45)=5.8%
2
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What is Book
Value?
Actual value of the assets of a
business.
Another term for shareholder
equity
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Book Value
• Total assets minus total liabilities
minus intangible assets
• Looks backwards
• Not accurate in some industries
• Affected by leases
• Affected by intangible assets
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Where do we find Book Value?
Book Value
10.45
Book Value
10.45
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Reminder:
Value Line uses
ROE = EPS divided by
AVERAGE book value per
share (an average of
beginning book value and
ending book value)
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BetterInvesting uses:
EPS divided by ENDING
book value per share
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Return on Equity
•Profitability
•Asset Turns
•Leverage
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What is
profitability?
• Section 2A - profit
before taxes
• Section 2B - after taxes,
not before taxes (as in
2A).
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Is it good to increase
profitability?
YES!
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What are asset
turns?
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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!
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Is it good to increase
asset turns?
Yes!
(but difficult)
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What is leverage?
Leverage is debt.
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It it good to increase
leverage?
MAYBE!!
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Debt can help a company
expand
BUT
Too much debt can be a
problem!
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• Debt can help a
company grow
• Too much debt can
destroy an unstable
company
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Let’s relate profitability,
asset turns and leverage
to our definition of
Return on Equity.
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ROE = Profitability x Asset
Turns x Leverage
• Profitability = Income divided by
Sales
• Asset Turns = Sales divided by
Assets
• Leverage = Assets divided by
Equity
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Now for some math…
Income
Sales
Sales
Assets
Assets
Equity
ROE
Or
Profitability x Asset Turns x Leverage = ROE
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Notice that some of the
items cancel out.
Income
Sales
Sales
Assets
Assets
Equity
ROE
This leaves us with our original
equation:
Income / equity
Income divided by equity = ROE
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Are all three terms equal?
Increasing profitability is good.
Increasing asset turns is good.
But..
Is increasing debt necessarily good?
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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.
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• Profitability x Asset turns x
Leverage
• Let’s assume:
Profitability = 2
Asset Turns = 2
Leverage =2
2 x2 x 2=8
ROE
•Let’s increase profitability to 4
4 x 2 x 2 = 16
Increasing
profitability
increases
ROE
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• Profitability x Asset turns x
Leverage
• Let’s assume:
Profitability = 2
Asset Turns = 2
Leverage =2
2 x2 x 2=8
ROE
•Let’s increase Asset Turns to 4
2 x 4 x 2 = 16
Increasing
Asset
Turns
Increases
ROE
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• Profitability x Asset turns x
Leverage
• Let’s assume:
Profitability = 2
Asset Turns = 2
Leverage =2
2 x2 x 2=8
ROE
•Let’s increase Leverage (debt) to 4
2 x 2 x 4= 16
Increasing
Leverage
(debt)
Increases
ROE
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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
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CAUTION!!
• Return on Equity can
be complicated and
deceptive!
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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.
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Can we spot which
factor is causing the
change in ROE?
Maybe…
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Other factors can also
influence Return on
Equity…
Acquisitions and mergers.
Expensing costs for research
and development under the
new accounting rules.
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When can we safely use
ROE?
• When a company
consistently carries no debt
• When we’re willing to do the
research
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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.
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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
BETTERINVESTING NATIONAL CONVENTION
Sources
• NAIC Stock Selection Handbook by
Bonnie Biafore
• Return on Equity Motley Fool
• Working with Financial Statements
www.usoiuxfalls.edu
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