Shareholders' equity or net worth is measured as company assets minus liabilities, which normally keeps growing for successful companies. Consequent to the 2001 collapse of Enron in the US, dozens of companies have confessed that they are worth far less than their books showed. The reason in many cases was that the assets that they paid a high price for few years earlier has gone down to its real value, i.e. a fraction of what the companies paid for. During the first quarter of 2002, some 154 Standard & Poor 500 companies lost $104 billion of net worth. Around 500 companies wrote down acquisitions that they made one to two years earlier. Leading the pack were AOL Time Warner with a shareholders equity cut down of $54 billion, Clear Channel with $16.8 billion and General Motors with $9.6 billion. Slashing shareholder's equity reduces the company stock price, decreases its debt rating thus raising its borrowing costs. In addition shrinking shareholder equity results in a poorer debit-to-equity ratio.
Return on equity, ROE, is calculated by dividing the company's earning per share by its book value, or net income divided by equity, and is quoted in percentage. In other words it is the percentage returned to owners on their investment. This figure measures the efficiency with which the company employs the owner's capital, and is highly correlated with the company stock price. A closer look reveals that ROE is made of three components namely profit margin, asset turnover, and leverage. The first two are operational and the last is financial. By properly balancing the three components, company executives try to maximize their ROE. Companies that have a ROE over 20% are seen by the financial community as doing well. A return of 15% in some sectors is acceptable. Companies that have a ROE around 10% are underperformers.
A company can improve its ROE by increasing earnings, improving productivity, reducing operating expenses, decreasing equity investment through outsourcing, or increasing sales. Returns on equity for the S&P 500 companies averaged between 10 and 15 percent for most of the twentieth century, but rose sharply in the 1990s. By the end of the decade, corporate returns on equity jumped above 20 percent. Many technology companies consistently produced ROEs return on book value, in excess of 30 percent in the 1990s. Due to this high ROE, investors were willing to bid their stocks to huge premiums to book value. While stocks traded between one and two times shareholders' equity throughout most of the century, they traded on average for more than six times shareholders' equity by late 1999.
Selecting companies with high ROE potential is the primary target for good investment. High ROE leads to strong earnings growth, a steady increase in shareholders' equity, a stable increase in the company's intrinsic value, and a sound increase in stock price. For example if Intel maintained a 30 percent ROE and it never paid a dividend, its net income and shareholders' equity would rise at 35 percent annual rates. As a result the stock should also rise at an annual rate of 35 percent over long periods. Investors and professionals are regularly challenged trying to select companies that can produce a high ROE. Forecasting this to any accurate degree has failed so far. However, there is a strong relationship between a company's ability to produce a consistent above average ROE and its track record of doing the same. In addition there is a correlation between the trend of a company's ROE and the trend of future earnings. If ROEs are climbing, earnings also should be rising. If the ROE trend of a given company is steady, chances are that the earnings tendency will likewise be steady and much more predictable. The challenge is whether the particular company can continue to produce the same percentage ROE annually. Due to competition, innovation, the aging of products and companies, it has become clear that no company can continue to produce a high ROE consistently forever. Competition tends to level the return on equity. Sustained high ROE indicates protection of a company's product or service through barriers to entry, as in the case of Microsoft and Intel, or an established brand name like Coca-Cola, Mercedes, and Sony, or through a sticky customer base like AOL, SAP, and Oracle. But even the above protection from competition has a time limit and it cannot be sustained forever.
--Salim J. Ghalayini, ghalayini@sa.ibm.com, is the author of Practical Investing. He manages several investment accounts.
Salim J. Ghalayini
© Arab News 2004
