Tuesday, June 5, 2012

Return on Equity Revisited

Monday's analysis of Dean Foods Inc. (DF) ran into a gigantic speed bump when it turned out that two major brokerages (E*Trade and TD Ameritrade) listed its return on equity as a negative 200%, and a respected analytical company (Zacks) had the ROE as a positive 50%.

What a huge difference! That's not just comparing apples to oranges. It's comparing apples to broccoli or apples to bangers & mash. The numbers aren't even in the same universe.

Every bump contains an opportunity, and in this case, the Dean Foods bump is a motivator for re-examining return on equity: What it is, why I use it, and whether I should be.

I first added return on equity into my analytical mix some 15 years ago, after reading a book by value investor Warren Buffett's former daughter in law, Mary Buffett, describing how the sage of Omaha thinks about money and companies. The book is called Buffettology, and up updated edition, The New Buffettology, was published in 2002.

This discussion, then, is Marry Buffett's characterization of how her former father-in-law thinks:

For Buffett, return on equity is a major tool in deciding whether a company is worth owning for the long haul. Buffett thinks of companies as though they were bonds. Bonds pay out a certain return on the face value -- the dividend -- each quarter or year. Companies earn a certain return on shareholders' equity -- the profits, or net income -- and report it each quarter.

The difference between bonds and companies is that bonds always pay out their dividends. Companies retain at least some of their earnings, and many return all earnings, paying out not one thin dime to shareholders.

Buffett is partial to companies that held on to their profits rather than scattering them to shareholders. He believes that by retaining earnings, companies can use them to make the company grow and earn even more, causing the price of shares to rise. It's a form of compounding, in Buffett's mind. The shareholder's payout comes in the form of more valuable shares -- capital gains.

So return on equity is important because it measures a management's ability to generate a profit -- a return -- on what the owners -- shareholders -- own -- shares of stock. It's a measure of management efficiency.

Now, I've always been a charts guy first and foremost. My trading time horizon is relatively short, and I've figured that the price and volume told me what I needed to know about what would happen to a company over the short haul.

But, I worked most of my life in the news industry, and by the 1990s I was seeing the beginning of what bad management could do to companies, in this case to newspapers. They failed to foresee the impact of the Internet. When it  became glaringly obvious, they failed to respond. The result today is not whether newspapers will have a return on equity but whether they will survive as viable businesses.

So I felt a need to go beyond the charts to get some sense of whether the company I was trading had a management likely to keep it afloat.

Return on equity seemed to be an excellent measure. Over time I added a few more items to my company health check-up list. Not a lot, because I had no need to go into the great detail outlined by fundamentalist traders like Harry Domash, whose excellent book Fire Your Stock Analyst outlines an elaborate chain of analytical tools to assess a company.

I wanted something quick and easy, so I could focus on more charts.

I look at the ROE for management efficiency, but also the debt/equity ratio -- long-term debt as a percentage of shareholder equity -- to see whether the company had earned its ROE by hawking the family jewels.

Later, I added the percentage of shares owned by institutions -- just to see what the big guns were doing -- and the price as a percentage of sales -- a measure of whether the price of the stock is low or high.

More recently, I started to look at earnings for direction and surprises, but not at the price/earnings ratio so loved by stock commentators. The P/E, after all, is just a reflection of what traders think of the earnings level, and trader opinion is notoriously fickle.

But return on equity remains my principle guidepost in assessing a company's health.

Return on equity, at its simplest, is the net income divided by the shareholder equity: How much the company made as a percentage of its value on the books to shareholders (as opposed to market value, or market capitalization, which is a very different thing).

A company has assets and liabilities, and what's left over is shareholder equity.

Sounds simple, but in the real world things rarely are cut and dried.

Shareholder equity includes money that will be paid out in dividends, if the company does pay dividends, and those dividends to common stock owners should count as equity. However, payouts to preferred shareholders should be subtracted, since they aren't part of equity.

The ROE is an annual figure, but what does that mean? Do you use equity at the close of the year and consider earnings to be the sum of four quarters? Do you use quarterly averages for each?

All of those methods include a lot of old data that may have little to do with how the company is doing today. It's like working with a 200-day moving average -- it's a slow moving beast and turns about as quickly as an aircraft carrier.

An alternative would be to use closing quarter's equity and only the last quarter's net income multiplied by four. This would be much closer to what's happening now, but earnings are often seasonal. Macy's (M), for example, like most large retailers, relies heavily on 4th quarter Christmas sales for the bulk of its annual earnings. Using the 1st quarter close and annualizing it would be horribly misleading.

Net income is routinely projected by analysts, as earnings estimates, although equity is not. Perhaps it would be best to multiply the closing quarter's equity by four to get an annual figure and then apply the earnings estimates.

That would certainly be a forward looking calculation, but it is only as good as the analyst projects. Sometimes -- quite often, actually -- analysts miss the mark. Using projections just moves the figure one step away from factual reality into the realm of market opinion.

Investopedia has a thorough discussion of how ROE is calculated. The Wikipedia article on the subject is also a worthwhile read.

A model called the Dupont Formula breaks down the ROE into components, one of which is sales. Perhaps return on sales is the better measure. Or perhaps not. Sales are just a part of a company's operations, and ROS fails to capture portions of what the company does. Efficient sales doesn't necessarily mean efficient everything.

In truth, there is no simple answer, or one that fits all trading situations.

But in light of the Dean Food anomaly, I'll be keeping other roads to the ROE in mind as a way of getting a clearer handle on the truth of it.

Meanwhile, in the case of Dean Foods, their 1st quarter report on file with the SEC shows shareholder equity (deficit, really) at a negative $52.7 million for the quarter, and net income $37.9 million. Annualized (multiplied by 4), the net income comes to $151.6 million, and return on equity is negative $287.7 million.

The trick is that no matter how much Dean Foods earns, if its shareholder equity is negative, the return will also be negative. Mathematically, a quarterly loss (negative net income) on negative shareholder equity would count as a gain (positive return on equity).

The best course, in my book, is that when shareholder equity is negative, no return on equity should be calculated. It should be treated the same as a divide by zero -- an error rather than a result. In that case, perhaps return on sales would be the best substitute measure.

That is the way I shall handle analysis going forward. I won't report a return on negative equity, and I'll look at return on sales as a substitute. Otherwise, I'll continue to give primacy to the brokerage figures for return on equity. They clearly reflect the dominant analysis.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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