CLASSES TO GO!

2B or Not 2B: Return on EquityRonald Bruyn, MBA

BIVAB Associate Director

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Disclaimer• The information in this presentation is for educational purposes only and is not

intended to be a recommendation to purchase or sell any of the stocks, mutual funds, or other securities that may be referenced. The securities of companies referenced or featured in the seminar materials are for illustrative purposes only and are not to be considered endorsed or recommended for purchase or sale by BetterInvesting™ National Association of Investors Corporation (“BI”) or the BetterInvesting Volunteer Advisory Board, its volunteer advisory board (“BIVA”). The views expressed are those of the instructors, commentators, guests and participants, as the case may be, and do not necessarily represent those of BetterInvesting™ or BIVA. Investors should conduct their own review and analysis of any company of interest before making an investment decision.

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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

EPS/Book Value

.59 / (9.78+10.45) x 100= 5.8%

2

The Value Line Calculation:

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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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• Profitability• Asset Turns• Leverage

Return on Equity

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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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Asset turnover is industry specific!

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.

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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

BUTToo 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 Assets

Sales Assets EquityROE

Or

Profitability x Asset Turns x Leverage = ROE

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Notice that some of the items cancel out.

Income Sales Assets Sales Assets Equity

This leaves us with our original equation:

Income / equity

Income divided by equity = ROE

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:

Increasing profitability increases

ROE

ROE

Profitability = 2 Asset Turns = 2 Leverage =2

2 x 2 x 2 = 8

•Let’s increase profitability to 4

4 x 2 x 2 = 16

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• Profitability x Asset turns x Leverage

• Let’s assume:

Increasing Asset Turns

Increases ROE

ROE

Profitability = 2 Asset Turns = 2 Leverage =2

2 x 2 x 2 = 8

•Let’s increase Asset Turns to 4

2 x 4 x 2 = 16

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• Profitability x Asset turns x Leverage

• Let’s assume:

Increasing Leverage

(debt) Increases

ROE

ROE

Profitability = 2 Asset Turns = 2 Leverage =2

2 x 2 x 2 = 8

•Let’s increase Leverage (debt) to 4

2 x 2 x 4= 16

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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

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Sources

• NAIC Stock Selection Handbook by Bonnie Biafore

• Return on Equity Motley Fool

• Working with Financial Statements www.usoiuxfalls.edu

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