Chapter 14

Determining the Strength of a Company's Return on Equity

In This Chapter

arrow Understanding the importance of return on equity

arrow Seeing how return on equity can guide investment banking activities

arrow Finding out how to perform a DuPont analysis

arrow Interpreting the results of a DuPont analysis

How do investment bankers, investors, and management judge how well a company is performing? For most publicly traded companies, the obvious answer would be how well the stock is doing. The bottom-line test of performance is often whether the value of the stock has risen or fallen in recent times and how the stock has performed relative to other publicly traded stocks in the company's industry or the broad stock market. But how should we judge the performance of privately held companies? What metrics do investment bankers look for when evaluating private companies and determining the feasibility of bringing such companies public via an initial public offering?

Investment bankers look to the numbers to see how a firm is performing relative to itself over time (in terms of a trend analysis) and against other companies. Generally this analysis is done by examining ratios calculated from financial statements like the balance sheet and income statement. As you saw in Chapter 8, there are a multitude of categories of ratios that investment banking analysts as well as investors can focus on:

  • Activity ratios: These ratios evaluate how efficiently the company is operating the business and focus on such functions as inventory and accounts receivable management, as well as what level of sales the firm achieves from its asset base.
  • Liquidity ratios evaluate the company's ability to meet short-term obligations such as paying suppliers, bondholders, and landlords.
  • Solvency ratios are the complement to liquidity ratios and measure the firm's ability to meet long-term obligations to bondholders, lessors, and other long-term creditors.
  • Cash flow ratios evaluate the company's ability to generate a sufficient level of cash flow to pay creditors and fund future growth.
  • Price multiples evaluate the price of the company relative to fundamentals such as earnings, sales, cash flow, or book value.
  • Profitability ratios evaluate the ability of the company to generate profits relative to revenue, invested assets, and owners’ equity.

Chapter 8 describes several profitability ratios including return on assets, return on capital, and return on equity. But in this chapter, you find out how to go beyond the fundamental ratio. In this chapter, you discover return on equity (ROE) and see why it's generally considered to be the most important metric for management, investors, and investment bankers. The chapter also explains why not all ROEs are created equal. That, in fact, two companies can have identical ROEs and one company can be in a much better financial position than the other company. With ROE, it isn't just the bottom-line number that counts; it's how the firm gets there.

Understanding the Importance of Return on Equity

The goal of most businesses in a capitalistic system is to make money for their owners because it's their money — they provide risky capital. Owners commit money to a company with the expectation that the company will put that money to productive use and that the owner will be handsomely rewarded for this commitment of funds by providing him with a return.

In fact, for years, business students have learned that the overriding goal of the corporation is to maximize shareholder wealth as measured by stock price. Financial markets not only reward individuals that productively use capital but also help to allocate capital to those businesses that consistently earn solid returns on the capital employed. But what are the primary drivers associated with rising stock prices and happy investors?

What return on equity shows

Investment bankers earn their paychecks by helping managers determine which actions are likely to result in an increase in shareholder wealth. But even if you can't take actions that directly result in an increase in shareholder wealth, you can take actions that, over the long term, are highly correlated with rising stock prices. The surest way to achieve that goal is by helping a company increase its return on equity.

As the name suggests, return on equity measures how well the company is producing a return on the money supplied by stockholders — the ultimate owners of the company. It's computed as:

  • 9781118615775-eq14001.eps

Return on equity is also important because it dictates how quickly a firm is able to grow internally — that is, by reinvesting earnings. When a company earns money, it can do two things with that money:

  • Reinvest the money in the firm.
  • Pay out the earnings as dividends to investors.

Typically, firms retain some of the earnings in the firm and pay some out as dividends. One of the key items investment bankers must estimate is the long-term growth rate in the earnings of a company:

  • Long-Term Growth Rate in Earnings = Return on Equity × (1 – Dividend Payout Rate)

tip_4c.eps The dividend payout rate is simply what percentage of net income the company pays out in dividends. For example, if a company earns $100 million and pays $25 million out in dividends, the dividend payout rate for that company is 25 percent. If that same company could average a return on equity of 20 percent, then its long-term growth rate in earnings would be

  • Long-Term Growth Rate in Earnings = 20% × (1 – 0.25) = 15%

There is a direct trade-off between dividends and future growth. The higher the dividend payout rate, the lower the future growth. Essentially, investors can receive their return now in the form of higher current dividends or later in the form of higher earnings and, hopefully, a higher stock valuation.

Some companies pay out a relatively large portion of their earnings in the form of current dividends, while others choose not to pay any dividends and, instead, reinvest all their earnings in the company to provide for future growth. Investors know this and companies generally develop dividend payout policies that attract certain types of investors. For example, many public utilities have very high dividend payout rates and are preferred by people who want to supplement their current income with dividend income.

Other more growth-oriented companies may have very low or no dividend payouts. Warren Buffett's Berkshire Hathaway, for example, has never paid a dividend. And the shareholders of Berkshire Hathaway are quite pleased that the firm hasn't paid dividends, because the firm has averaged a 19.7 percent compound annual return over 45 years from 1968 through 2012. Just $1 invested in Berkshire Hathaway in 1968 would've grown to over $3,267 by the end of 2012!

Later in this chapter, we explain how to closely examine the profitability of the Coca-Cola Company and break down the profitability of Coca-Cola into its component parts. But, as a preview, take a look at Table 14-1 and see how consistently high Coca-Cola's return on equity has been over the past ten years.

Table 14-1 Return on Equity for Coca-Cola

Year

Return on Equity

2012

27.4%

2011

27.1%

2010

37.8%

2009

27.5%

2008

28.4%

2007

27.5%

2006

30.8%

2005

29.6%

2004

30.3%

2003

30.8%

Both the level of ROE and the consistency of ROE indicate that the Coca-Cola Company has a terrific business model and is incredibly well managed. These kinds of results are what firms strive to provide for shareholders.

Pros and cons of return on equity versus other profitability measures

Return on equity isn't the only profitability measure that investment banking analysts pay attention to, although it is arguably the most important one. Several other measures deserve consideration, and we calculate them in this section, explaining how they work for one of the most popular companies with investors and the general public, the Coca-Cola Company (ticker symbol: KO).

You probably already know Coca-Cola is a ubiquitous brand around the world. In fact, none other than Warren Buffett himself has indicated he thinks that it's the best brand in the world. A measure of the strength of Coke's brand is that there are Coca-Cola stores online, in New York City, and in Las Vegas. When people will pay you to advertise their brand, you know you have a strong franchise.

Table 14-2 presents abbreviated financial statements (income statement and balance sheet) from the Coca-Cola Company for the years 2010, 2011, and 2012.

1402
1402a

Source: EDGAR

The other profitability measures that investment bankers consider are gross profit margin, operating profit margin, and net profit margin. In the following sections, we compute each of these measures for year 2012 and explain the significance.

Gross profit margin

Gross profit equals sales minus the cost of goods sold. Coca-Cola's gross profit margin for 2012 is computed as follows:

  • 9781118615775-eq14002.eps

This profitability measure shows the basic cost structure of the firm and, like many calculated measures, is very industry specific. The beverage industry is characterized by very wide margins. The actual cost to produce and bottle the product is fairly low. The real significant costs come in advertising and building the brand.

Over the last three years, Coca-Cola has been able to maintain a fairly stable gross profit margin — the margins were 60.9 percent and 63.9 percent in years 2011 and 2010, respectively.

remember_4c.eps It's not enough to just eyeball one year's gross profit margin and think that tells you much. One thing investment bankers would key their eye on with the Coca-Cola example is the fact that the trend in the ratio is down slightly. Further erosion in gross profit margin over the next couple years may be cause for concern.

Operating profit margin

Operating profit (also known as earnings before interest and taxes) is gross profit minus sales, general, and administrative expenses (SG&A). Coca-Cola's operating profit margin for 2012 is computed as follows:

  • 9781118615775-eq14003.eps

This profitability measure tells you what percentage of sales is left over after paying all costs prior to paying the suppliers of capital (stockholders and bondholders) and Uncle Sam (taxes). This gives the analyst an idea of what's left (on a percentage basis) to pay taxes and the suppliers of capital. An eroding operating profit margin would be cause for concern.

Over the last three years, Coca-Cola has been able to maintain a very stable operating profit margin — the margins were 21.9 percent and 24.0 percent in years 2011 and 2010, respectively. This would indicate to the analyst that over the last three years, Coca-Cola has experienced very little business risk.

Net profit margin

Net profit margin is defined as bottom line net income (after taxes and interest expense have been paid) divided by sales. Coca-Cola's net profit margin for 2012 is computed as follows:

  • 9781118615775-eq14004.eps

Simply put, net profit margin measures how much of every dollar of sales the company is able to keep as earnings. Over the last three years, Coca-Cola has had very enviable net profit margins — the margins were 18.6 percent and 33.7 percent in 2011 and 2010, respectively. Now, you may think that analysts would be concerned that net profit margin declined considerably from 2010 to 2011. However, when you dig deeper, you see that this was the result of a one-time, extraordinary gain from the acquisition of Coca-Cola Enterprises North American business operations. A net profit margin in the neighborhood of 19 percent is more consistent with the history of the company.

How return on equity can help guide an investment banking deal

Companies looking to expand and grow often look to acquire other companies to fuel that growth. And one of the most attractive elements of any acquisition target is its ability to generate a high return on equity. So, investment bankers will scour the markets looking for firms that are able to provide high returns to shareholders and hope that deals can be structured so that those firms can be purchased at an attractive price.

remember_4c.eps It isn't simply the final return on equity number that matters most to a savvy investment banker. Instead, how a company achieves that return on equity is crucial to determining whether a company is an attractive acquisition target. Is the high return the result of borrowing a lot of money — does leverage fuel the return? Is the return the result of high profit margins, or does it result from modest profit margins and high turnover? These questions are the kind that investment bankers must provide answers to when pitching potential deals to company management. DuPont analysis is a well-established and widely used tool to provide systematic answers to these questions.

Using a DuPont Analysis

In golf, an old adage says, “We aren't painting pictures, we're writing numbers.” What this means is that, on a given hole, it doesn't matter how a certain score is achieved — what matters is the number that a golfer ultimately writes on his scorecard. One golfer could have hit a couple of awful shots on a hole, ended up in a bunker or two, but managed to escape the hole with a par because of one miracle shot. His playing partner could've hit all very solid shots and ended up making the same score. Yet, for that hole, the two competitors were equal.

Obviously, over the long haul, the chances for success are dramatically different for those two competitors if their play on that hole was indicative of their overall play.

The same is true for companies and the evaluation and comparison of their respective ROEs. For companies, as we explain in this section, what matters isn't just the number they write on their scorecard (their financial statements), but how they get to that number. In other words, not all ROEs are created equal, and that's what DuPont analysis is designed to highlight.

Essentially, the DuPont model breaks down return on equity into its component parts and helps provide the analyst with a road map on what the company is doing right and where improvement is possible and perhaps warranted. The results of the DuPont analysis can be compared for the same firm across time via a trend analysis or can be compared to other companies in a cross-sectional analysis.

The three-factor DuPont method

There are two formulations of the DuPont method — the three-factor method and the five-factor method. The three-factor method shows that return on equity is a function of the product of three different ratios:

  • Net profit margin
  • Total asset turnover
  • Leverage

A higher ROE can be achieved by an increase in any of the three ratios.

We cover net profit margin earlier in this chapter. Total asset turnover is defined as sales divided by total assets and is calculated for Coca-Cola in 2012 as follows:

  • 9781118615775-eq14005.eps

Total asset turnover provides an indication of the effectiveness of the firm's use of its asset base. All else equal, a higher total asset turnover is better than a lower one. Total asset turnover is a metric that varies by industry. Total asset turnover at Coca-Cola for the years 2011 and 2010 was 0.583 and 0.482, respectively.

warning_4c.eps One of the easiest (and also one of the riskiest) ways that a firm can increase its ROE is to borrow more money. This practice is known as leverage, and just as in the physical sciences where a strategically placed lever can allow someone to move a large object with a little bit of force, strategically borrowing money can allow a firm to magnify returns. In fact, leverage works when you can make more money on the borrowed money than it costs you. Of course, leverage is often referred to as a double-edged sword because leverage can magnify losses when you make less money (or you lose money) on borrowed funds than they cost you. Many people learned about leverage the hard way with residential real estate in the recent financial crisis.

The leverage ratio is defined as total assets divided by stockholders’ equity. So, a firm with no borrowed funds would have a leverage ratio of 1.0. The leverage ratio for Coca-Cola for the year 2012 is as follows:

  • 9781118615775-eq14006.eps

This leverage ratio indicates that a substantial portion — over 50 percent — was being supplied by borrowing funds (both short term and long term) for the year 2012. The leverage ratios were 2.328 and 2.505 for years 2010 and 2011, respectively. The leverage ratio is expanding slightly. All this debt may seem very risky, but for a firm with very little underlying business risk, like Coca-Cola, it's a prudent strategy.

Putting it all together

As we mention earlier, a firm's ROE is the function of the product of three different ratios. For the year 2012 for Coca-Cola, the DuPont analysis is as follows:

  • 9781118615775-eq14007.eps

This type of breakdown provides an investment banker with a great deal of insight on how a firm may go about improving its return on equity. In the case of Coca-Cola, it's hard to imagine that there is much room for improvement, but one area may be in total asset turnover. Of course, Coca-Cola could increase its total asset turnover simply by slashing the prices of its products. However, that would lower its net profit margin. The key for Coca-Cola is to strike a balance between selling more product and not eroding its net profit margin.

The five-factor DuPont method

A further refinement of the three-factor DuPont model is achieved by breaking down net profit margin into its three components:

  • Operating profit margin
  • The effect of non-operating items
  • The tax effect

Through this analysis, the investment banker can get a better idea on how that net profit margin is being generated and see if there are any troubling trends. We explain each of these three components in the following sections.

Operating profit margin

We introduce operating profit margin earlier in this chapter. It's defined as earnings before interest and taxes divided by sales; for Coca-Cola in 2012, it was 22.4 percent. This is the percentage the company earns on sales before paying Uncle Sam and the suppliers of capital. The key here is that it involves income from operations — what the company is in the business of doing (in the case of Coca-Cola, making and selling beverages). It does not include extraordinary items (such as selling a plant or spinning off a division) or take into account the payment or receipt of interest payments or the paying of taxes.

Effect of non-operating items

Oftentimes, companies have significant non-operating items that affect profitability. The effect of non-operating items takes into account everything in the income statement between its operating income (EBIT) and its earnings before taxes (EBT). For Coca-Cola, from Table 14-2, you can see that these non-operating items include interest income, interest expense, equity income, and other income.

Coca-Cola both receives and pays interest. But that isn't their main business. Coca-Cola's main business is bottling and selling beverages. Segmenting these sources of income and expenses allows the analyst to isolate the effects of the main business.

Likewise, Coca-Cola has equity income (income that the company receives from investments in other businesses) and other income (one-time extraordinary items). When evaluating the profitability of the main business of Coca-Cola, these items should not be included.

The effect of non-operating items is simply reflected in the five-factor DuPont analysis as EBT divided by EBIT. For the year 2012, for Coca-Cola, this calculation is as follows:

  • 9781118615775-eq14008.eps

If a company has more non-operating expenses than non-operating sources of income, this ratio is less than 1.0. If, like Coca-Cola, the company has more non-operating sources of income than expenses, this ratio is greater than 1.0.

In 2010, 2011, and 2012, this ratio varied dramatically for Coca-Cola. In 2010, the ratio was 1.689; in 2011, it was 1.126. The dramatic increase in 2010 was due to the one-time, extraordinary gain from the acquisition of Coca-Cola Enterprises North American business operations that we mention earlier. The point to be made here is that the five-factor DuPont analysis draws the analyst's attention to that occurrence.

Tax effect

The last ratio included in the five-factor DuPont model is the tax effect. Essentially, this tells the analyst what percentage of EBIT the company is able to keep to be able to provide a return to the suppliers of capital. This ratio is simply 1 minus the company's realized tax rate. For 2012, this ratio for Coca-Cola is computed as follows:

  • 9781118615775-eq14009.eps

This ratio indicates that Coca-Cola paid an average tax rate on earnings of 23.1 percent, and the firm was able to keep 76.9 percent of earnings. The ratios for 2010 and 2011 were 0.833 and 0.755, respectively. Once again, the ratio for 2010 was skewed by the extraordinary item.

Putting it all together

The five-factor DuPont model breaks down return on equity into the five components described earlier. For Coca-Cola for the year 2012, the five factor DuPont model is as follows:

  • 9781118615775-eq14010.eps

This analysis provides the analyst with more detail and more insight as to how Coca-Cola is generating its remarkable return on equity.

Interpreting the Results

Up to now, we've looked only at Coca-Cola and compared how ROE and the components in ROE for both the three- and five-factor models have trended over the past few years. One of the most illuminating aspects of DuPont analysis is to compare a company to the industry it operates in and to its chief competitors.

Cola wars

You've likely heard about the blindfolded taste tests that ask consumers to compare the taste of Coke and Pepsi to each other. Financial analysts can do a variation of the taste test to see which company “tastes” better to investors.

The data in Table 14-3 allows the analyst to perform a three-factor DuPont analysis on Pepsico and compare the results to that of the Coca-Cola Company.

1403

Source: EDGAR

The first thing to notice is that Coca-Cola and Pepsico are of comparable size when looking at sales, total assets, and stockholders’ equity. Investment bankers are very careful not to use companies that are of dramatically different size when doing cross-sectional comparisons. A multi-billion-dollar global firm should not be compared to a smaller, regional firm even if they're in the same fundamental industry.

Table 14-4 presents a three-factor DuPont analysis of Pepsico and the Coca-Cola Company for the years 2010 through 2012.

1404

What the numbers mean

The Coca-Cola Company and Pepsico are two remarkably well-run firms in a business that is really pretty simple and doesn't rely on sophisticated technologies. In fact, these two beverage giants have become the dominant global players in an industry that has very small barriers to entry. They've both built remarkable global brands. In fact, Interbrand — a global brand consultancy firm — has ranked Coca-Cola the number-one brand in the world and has ranked Pepsi 22nd.

The return on equity — the return that both companies have earned on shareholder equity — is quite high and consistent over the time period studied. Any investor would have been thrilled to have their money providing these kinds of returns over the past three years.

remember_4c.eps A close perusal of the three-factor DuPont model shows that the firms get to their near identical ROEs in very different ways. Pepsico's net profit margin is roughly half that of Coca-Cola, while its total asset turnover is substantially higher. Additionally, Pepsico is a much more highly leveraged firm than Coca-Cola is.

Looking past the numbers for insight

The case of the cola wars provides a prime example of Warren Buffett's quote on investing: “There's more than one way to get to heaven.” What Buffett meant by this was that good investment results can be achieved using various methods. Coca-Cola has a business model that relies on a higher net profit margin, lower turnover and lower leverage than Pepsico. The good news for Coca-Cola is that the firm could conceivably take on more debt in its capital structure to magnify returns in the future. Pepsico has less room to take on more debt.

Likewise, Coca-Cola has very wide net profit margins and would likely be able to prosper during a protracted price war in the beverage industry. Pepsico's net profit margin is already fairly thin, and it doesn't have as great a margin of safety in this area as Coca-Cola does.

Where Pepsico shines is in its ability to generate a given level of sales per dollar of assets. The area that Coca-Cola could conceivably improve upon is generating more dollars of sales on its asset base.

But how does the market view Coca-Cola and Pepsico? One way of answering this question is to see what multiple of current earnings these firms are selling for in the market. As of August 2012, Coca-Cola was selling at nearly 21 times earnings and Pepsico was selling at slightly under 20 times earnings. Both companies were selling at a premium to the market, because the Dow Jones Industrial Average was selling at around 17 times earnings. The fact that the market is ascribing a premium to the earnings of both firms shows that these are very well-run companies with terrific future prospects.

Telling companies how to react to the numbers

Coca-Cola and Pepsico aren't attractive takeover candidates. They're simply too big, and the market has already recognized the value in these firms. However, going through the DuPont analysis of both firms is instructive when thinking about ways that investment bankers can counsel companies to make them better acquisition candidates.

remember_4c.eps Companies must focus on providing an attractive return on equity. This is the most important metric for companies looking to be acquired by other firms or looking to go public themselves. Investors focus on ROE, so firm managements must focus on ROE.

Also, companies must realize that even though the bottom-line ROE number is extremely important, it's equally important that number be realized in an attractive manner. In other words, investors and potential buyers aren't fooled by high ROEs that are achieved merely by high degrees of leverage. In fact, the most attractive firms are those with solid ROEs that also have unused borrowing capacity — firms that can be “leveraged up” to realize even higher ROEs.

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