New Threads Only:  Add to Google Reader or Homepage
New Threads & Replies:  Add to Google Reader or Homepage
Forums are for serious investors only. GuruFocus Forum Rules.

Forum List » Guru News and Commentaries
Guru News, Stock picks and commentaries
New Topic Search
Goto Thread: PreviousNext
Goto: Forum ListMessage ListNew TopicSearchLog In
Why Ratios Like Return on Assets and Dividend Payout Are Calculated Wrongly
Posted by: Mark Lin (IP Logged)
Date: November 19, 2012 11:58AM

I get asked two questions on dividend payout very frequently. The first question is why a loss-making company can still pay dividends. The second question is why a company pays so little of its retained earnings.

Both questions are the result of severe misconceptions, partly due to how accounting deals with dividends.

In double-entry accounting, when the company pays out a cash dividend, the retained earnings account is debited and the cash credited, reflecting a reduction in the retained earnings balance and the cash balance. However, the debiting of the retained earnings or accumulated profits balance is an accounting charge. Dividends are, and have to be, paid out from cash.

Going back to answering the first two questions at the start of this article, a loss-making company can still pay dividends as long as it still has cash on the balance sheet. With respect to the second question, retained earnings reflect the accumulation of accounting earnings over time but not necessarily cash-generating ability and cash availability.

It also brings to the table an important fact: The dividend payout ratio has always been and is still calculated wrongly. The denominator in the dividend payout ratio should be free cash flow, instead of accounting earnings.

It is the same issue with the return on assets calculation (ROA). ROA is meant to be differentiated from ROE by the fact that ROA is a pure operating measure independent of financing. The denominator in the ROA calculation should be operating income instead of net income which reflects financing decisions with the deduction of interest expense. In recent years, return on invested capital has been gaining in popularity over ROA and even ROE as a measure of company value creation.


Stocks Discussed: SPY, DJI, QQQ,
Rate this post:

Rating: 3.6/5 (7 votes)



Re Why Ratios Like Return on Assets and Dividend Payout Are Calculated Wrongly
Posted by: ry.zamora (IP Logged)
Date: November 20, 2012 09:47AM

Mark,

You'll find that RNOA or "Return on Net Operating Assets" is a more precise measure of returns on operations as it employs operating income (typically adjusted further for taxes). This is typically compared to ROE to determine how much of returns come from operations. From experience, anything above 100% indicates financial leverage is a burden on the company's profitability.

What you should reflect over perhaps is the analysts' metric for efficiency: the asset turnover ratio. That is something calculated wrongly. All I have to do is ask you one thing: at the end of the day, should the concept of "efficiency" be equated to the "ability to generate sales"?

The commonsense answer should be obvious. Blatant, in fact.


Stocks Discussed: SPY, DJI, QQQ,
Rate this post:

Rating: 1.0/5 (1 vote)



Re Why Ratios Like Return on Assets and Dividend Payout Are Calculated Wrongly
Posted by: marklin (IP Logged)
Date: November 21, 2012 06:27AM



Hi Ry.zamora, thanks for your inputs.

I agree with you that RNOA and/or ROIC are better measures of returns. For adjusted measures and ratios like RNOA and ROIC, the recasting of the financial numbers and the definition of operating income and net operating assets/invested capital becomes crucial to the quality of the measure.

As you pointed out correctly, besides ROA and dividend payout, there are many misused and misunderstood ratios and measures out there. However, the fault lies with the user, not the tools. Users of financial statements and ratios have to apply caution and discretion in calculating and interpreting such numbers.



Stocks Discussed: SPY, DJI, QQQ,
Rate this post:

Rating: 1.0/5 (1 vote)



Re Why Ratios Like Return on Assets and Dividend Payout Are Calculated Wrongly
Posted by: batbeer2 (IP Logged)
Date: November 21, 2012 07:37AM

>> However, the fault lies with the user, not the tools. Users of financial statements and ratios have to apply caution and discretion in calculating and interpreting such numbers.

Yes!


Stocks Discussed: SPY, DJI, QQQ,
Rate this post:

Rating: 2.0/5 (1 vote)





Sorry, only registered users may post in this forum.

Please Login if you have an account or Create a Free Account if you don't
Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK
Email Hide