Given that investors prefer higher ROE, the market value of a dollar is greater if it was earned using less equity. The logic being, that a dollar retained in a high ROE business will generate superior returns in future.
The simple way to calculate ROE is to divide twelve months of earnings by the average shareholders equity over that period. Oh and multiply the result by 100 to get a percentage. This article would be done now if there were not an alternative way to calculate ROE.
I ROE = (assets/equity) x (revenue/assets) x (net income/revenue)
Cancel out assets and revenue and you get back to the method above. Substitute “Net margin” for (net income/revenue), “Leverage” for (assets/equity) "Asset turnover" for (revenue/assets) and you get:
II ROE = Asset turnover x Net margin x Leverage
As an aside,
III ROA = Asset turnover x Net margin.
That makes sense, the difference between ROE and ROA is leverage.
In any case, formula II lends itself to some further analysis. Remember, investors prefer high ROE businesses because a dollar retained is more effective. Well…. high leverage is not an indication of an effective core business. In fact, retaining a dollar in a highly leveraged business reduces leverage and therefore ROE.
High net margin on the other hand is a good thing. However, it may be due to external factors and therefore unsustainable (cyclical businesses suffer from margin compression and expansion). It may also be due to aggressive accounting or GAAP “features”. Also, net margin may be temporarily depressed due to say litigation costs or writeoffs. In many cases, the retention of a dollar earned is not a good idea simply because a business has high net margin.
This leaves us with what IMO is the most fundamental factor in the equation for ROE…. asset turnover. A business with superior asset turnover has a competitive advantage within its industry. A dollar retained there is truly more effective than the same dollar retained elsewhere.
Just to give the gurufocus crowd something to poke at let’s see if this is of any use in selecting stocks.
Stock; 1999 asset turnover; 1999 EPS; 2009 EPS
WMT; 2.4; $ 1.21; $ 3.46
TGT; 2; $ 1.30; $ 2.87
GD; 1.3; $2.27; $6.22
NOC; 0.9; $3.36; ($3.86) some non-cash charges there though !
JNJ; 1; $1.55; $4.44
PFE; 0.8; $0.82; $1.2
Two final notes…..
1) Just taking two stocks with equal P/E and buying the one with the highest asset turnover may not be a good idea. Earnings growth depends on a lot of factors; but if you have two companies that have an identical macro environment, the one with the highest asset turnover has an advantage.
2) A company is not great because it has great accounts. The accounts are great because the company is. Understanding just why a company is superior is the key to selecting the right growth stocks.
Remember, do not overpay.