05-19-2015, 04:26 PM
(05-19-2015, 02:21 AM)Dividend Watcher Wrote: stewardinlife posed this question in his introduction thread:
(05-12-2015, 05:10 PM)stewardinlife Wrote: Have a question on ROE (return on Equity). As I am educating I am finding one of the healthy criteria in selecting a company is an ROE of 15% or greater. The PM stock seems to be having ROE of -64.67% -- This seems to be way under the desired value.
I've been without Internet at home for almost 2 weeks as we switch over to Time Warner. Being in the middle of a corn field, they had to bring the Internet in by mule train. That and being busy precluded me from sitting down and writing some kind of response. I hope SIL didn't feel we were ignoring him. Since I think it is a pretty important concept, I moved it over here in case others would care to listen to me blather on about it.
I first want to rehash just what is this thing called Equity. It helps to understand where that fits in with a company's financial structure. For that, I turn to the accounting equations that form the basis of the financial reports:
The first equation is a snapshot in time of what a company owns and what it owes. Equity is what's left over after all the liabilities are paid. You can read a little more about them and a big discussion on depreciation over at this thread.
- Assets = Liabilities + Equity (Balance Sheet)
- Profit = Income - Expenses (Income Statement, Profit & Loss Statement and lately also called the Statement of Earnings)
If you look at company balance sheets in annual reports or Form 10-K's, you'll often see more than just one line item under equity.
1. Common Stock (and sometimes Preferred Stock) par values along with the number of shares issued. This is basically a book entry for the corporation to account for the shares issued. Typically the value is some miniscule amount that doesn't affect the company valuation in any appreciable manner. It really tells you nothing about what the stock or the company is worth.
2. Additional paid in capital. This accounts for additional money received by the corporation above the par value of issued stock. It originates when
the company is founded and/or when additional shares are issued and sold to investors. Because it has a tortuous past -- it takes into account all the share buybacks, restricted stock options, subsequent issues, etc. over the years -- it really does not add much to your understanding of a company's financial condition. The company does have to account for it so there it is.
From these two, you can subtract out the cost of shares held in the corporate treasury. These can be the result of buybacks or shares that were issued but not in the hands of investors - yet. Since they are issued shares and not solely the property of the company in theory (afterall, the company issued them for a reason in the first place -- to raise capital?) they are subtracted from equity because they can be used for any purpose; think management and director compensation or acquisitions. I believe this is a GAAP requirement.
3. Accumulated other income or deficit. This includes such things as foreign currency translations, pension & post-retirement liabilities and currency hedging results. Again, this value should not be very significant but can be a warning sign if significant underfunding of pension obligations exists.
4. Retained earnings. This is the big part of equity or at least should be. Basically, this is the cumulative total of the "bottom line" from the Income Statement or Statement of Earnings -- the other big equation mentioned above -- since the founding of the company and all its accompanying adjustments. This is after dividends are paid and subtracted out. In other words, this is what you own free & clear as a shareholder and is often called Book Value.
Now for the fun part . . .
If you remember from the thread on depreciation, I like to relate the two equations above by using profit = equity. If you think it through, every income or expense item that is recorded over the course of a year causes profit to go up or down and likewise equity. That doesn't happen in isolation. If equity goes up, then something has to happen with assets or liabilities (or both) to keep the first equation in balance. Hence, if you sold some products:
Profit (+$600) = Income (+$1000) - Expenses (the cost to produce product; -$400)
If Profit = Equity,
Assets (+$600) = Liabilities + Equity (+$600)
you put the money in the bank, an asset.
Notice that we didn't say a thing about debt or liabilities. That's because both assets & liabilities are balance sheet items. You issue $1 million in debt and then put that in the bank until you spend it, assets go up by $1 million in the bank and liabilities go up $1 million for the debt so the equation is kept in balance without affecting equity.
Now, getting down to SIL's question.
Return on Equity (RoE) is defined as (net income)/(shareholder equity). So if you make a lot of money and your equity isn't very big relatively, RoE can be huge. Likewise, a large and old corporation that has a pretty big Retained Earnings balance -- they didn't pay a big dividend for example-- would have to make bunches cash to produce a respectable RoE.
Let's say a corporation is loaded up with debt. Hopefully, it has quite a balance of assets too for plants & equipment, maybe a bunch of inventory, money in the bank for day to day expenses, etc. Let's see what happens.
Over the course of the year, those assets are depreciated by a fractional amount of what they're worth. Additionally, they have to make interest payments on those bonds they issued. Both of those are expenses in the profit & loss equation. That tends to lower earnings all else being equal. Profit goes down and equity goes down (not as much added to Retained Earnings). To keep the balance sheet equation in balance, assets &/or liabilities must go down also. Since you're not paying principal on the debt, then liabilities stay the same but assets are valued less because of depreciation.
For an example, I'm going to describe a new company. We're going to ignore all the incidental expenses like payroll and costs to produce since they could be the same no matter what we do. This new company sells $10,000 in bonds (debt) for 20 year maturity at 7% interest rate to buy a plant and uses a 20 year useful life for straight line depreciation of the plant. The plant has sales of $3,000/year which it can't easily change because of competition and it's a young company so retained earnings are minimal.
Plugging in those numbers with income staying constant:
Profit = Income - Expenses
Profit (+$1800) = Income ($3000) - Expenses (-$500 depreciation, -$700 interest)
Since profit = equity:
Assets (+$10000 plant -$500 depreciation +$1800 to bank) = Liability ($10000) + Equity (+$1800)
9500 + 1800 = 10000 + 1800
11300 = 11800 ????
Quite the quandary here, right? I wanted to leave this in since it is so often overlooked and it's so important to us dividend growth investors. Remember that depreciation is a NON-CASH expense and must be added back to our assets. In other words, even though it lowered our profits to $1800, the money we can actually take to the bank is $2300! This is cash flow which we haven't discussed yet although that may be a topic for another day.
So correcting for that:
Assets (+10000 plant -$500 depreciation +$2300 to bank) = Liability ($10000) + Equity (+$1800)
Adding them all up balances the equation and we are good. Now let's look at Return on Equity using our example above.
RoE = (net income) / (shareholder equity)
RoE = $1800 / $1800
RoE = 1.00 or 100% <- that's great!
Now let's fast forward 10 years with the same metric every year. In 10 years, the plant is half way depreciated, the debt's still there and $1800 was added to Retained Earnings every year.
Assets (+$10000 plant -$5000 depreciation +$23000 to bank) = Liability ($10000) + Equity (+$18000)
$28000 = $28000 <- so far, so good
RoE = (net income) / (shareholder equity)
RoE = $1800 / $18000
RoE = 0.10 or 10% <- is this good or bad???
Now let's look at the 20 year point when the debt is paid off:
Assets (+$10000 -$10000 depreciation +$46000 to bank -$10000 pay debt) = Liability ($10000 -$10000 payoff) + Equity (+$36000)
$36000 = $0 + $36000 <- again, we're good
RoE = (net income) / (shareholder equity)
RoE = $1800 / $36000
RoE = 0.05 or 5% <- yuch!
At the 20 year point, the RoE looks terrible yet for 20 years they've made $1800 profit (and $2300 in cash flow) every year without changing a thing. Of course, it's a pretty simple example but I didn't want to complicate things.
As an aside for dividend growth investors, if this fictional company started paying out dividends at 20% of net profits in the first year and increased them at 7% per year, for 20 years, they'd still be at a payout ratio of only 77%. Additionally, since retained earnings do not include dividends, the return on equity would be that much higher (denominator is lower) all else being equal.
Now imagine a company that didn't need to go into as much (or no) debt. How about a software company that only had payroll and some computers? Interest payments and depreciation would be much less. Plug in some numbers and see where that works out.
stewardinlife, what I was trying to say through this whole exercise is that RoE is not the same for different industries and, of course, company financial structures. Using a 15% or better benchmark as good but less than that is bad is very misleading. Yes it's a good way to separate some companies if that's what you're looking for. Other times, it can blind you to perfectly good companies. Utilities rarely reach a RoE of 15% yet they can produce a pretty good & reliable income stream. Look at what other companies in the same or similar industry are doing for a gauge on how well management is using their money. Some have suggested that to truly gauge how successful a company is doing, RoE should be compared with its weighted average cost of capital (WACC). Now you're looking at much more company-specific metrics rather than a single benchmark.
PM is an interesting point. I didn't have time to dig into their equity history. Presumably, with the split from MO, equity was negatively affected for a variety of reasons. I saw the same thing when I was analyzing CMP. Dig into the notes to the financial statements for an answer. Coincidentally, I own PM but equity did not concern me. I assumed the split had as much to with the numbers as anything. I am more concerned on how well they do operationally every year. Are they able to increase profits and the dividend?
Hope this helps you understand a little more of what you're looking at.
DW, thanks so much for writing a nice tutorial, and explaining it clearly! Appreciate it. I know I'll be re-reading it many times!