Karen Rogers

# Using the 3Rs to Find Investment Value

Analyzing financial statements is a fundamental approach to assessing a company’s value and profitability. However, numbers alone do not provide all the information you need to determine if a company’s stock is worth buying. Using the 3Rs – Return on Investment, Return on Capital and Return on Equity lets you compare which company is better suited at turning your investment dollars into profit.

Comparing Profit Ratios

The 3Rs are most effective when comparing similar size companies in the same sector and industry. Both Avago Technologies (NASDAQ:AVGO) and Analog Devices Inc. (NASDAQ:ADI) are in the information technology sector and the semiconductor industry. The data was taken from the 2013 financial statements found in each company’s prospectus.

 AVGO ADI Market Cap 15.4B 16.5B Net Income 552M 673M Dividends 198M 406M Long-term Debt 1M 872M Shareholders’ Equity 2.886B 4.74B

Return on Investment Ratio

The Return on Investment, or ROI, ratio shows how much money a company either makes or loses from a project, product or asset. The formula is:

ROI: Income (before Extras and Discontinued Operations / (Long-term Debt + Non-current Capital Leases + Mortgages + Book Value of Preferred Stock + Common Stockholder Equity)

You can find the information to calculate the ROI ratio on the income statement, or use the pre-calculated ratio available from a free online financial news provider. A positive ROI means the company’s return exceeds the cost of capital while a negative ROI, or negative return, means the company is not generating enough cash to cover the capital costs. The greater the ROI ratio, the more money a company makes or loses for each dollar of capital it invests in a project, product, or asset.

AVGO’s 19.98% ROI means that for every \$100 the company invested, it earned \$119.98 and netted a \$19.98 profit.

ADI’s 12.60% ROI, although positive, means that the company netted a profit of \$12.60 for every \$100 invested.

Compared to competitor ADI, AVGO earns an additional \$7.38 for each \$100 it invests.

Return on Capital Ratio

The Return on Capital, or ROC, ratio shows how much profit a company earns from investing its capital in different products, projects and assets. The formula is:

ROC: Net Income - Dividends / Total Capital

The net income and dividend amounts are found on the income statement. The total capital is the beginning balance of the long term debt and the stockholders’ equity accounts found on the balance sheet. A positive ROC means that the company is using the capital invested in its projects, products and assets to make a profit while a negative ROC means that the company is losing money. The higher the positive ROC ratio, the more efficiently a company turns capital into profit.

AVGO ROC: 552,000,000 – 198,000,000 / 1,000,000 + 2,886,000,000 = 12%

AGI ROC: 673,000,000 – 406,000,000 / 872,000,000 + 4,740,000,000 = 5%

AVGO earned a 12% return on its invested capital, which means for every \$100, AVGO earned \$112, netting a \$12 profit. In comparison, AGI’s 5% return means that the company earned \$105 for every \$100 invested, netting a \$5 profit.

By using its capital more efficiently, AVGO earned an additional \$7 from each \$100 capital investment.

Return on Equity Ratio

The Return on Equity, or ROE, ratio narrows down the ROC ratio to shows how much profit a company generates from its stock sale proceeds. The total shareholder equity amount is found on the balance sheet. The net income amount is found on the company income statement. The formula is:

ROE: Net Income / Shareholder Equity

A positive ROC means that the company is using its stock sale proceeds to make a profit. A negative ROC means that the company is losing money from its stock sale proceeds investments. The higher the positive ROC ratio, the better a company is at turning stock sale proceeds into profit.

AVGO ROE: 552,000,000 / 2,886,000,000 = 19%

ADI ROE: 673,000,000 / 4,740,000,000 = 14%

AVGO earned a 19% return on the money shareholders invested in the company, which means for every \$100, AVGO earned \$119, netting a \$19 profit. In comparison, AGI’s 14% return means that the company earned \$114 for every \$100 invested, netting a \$14 profit.

By using the money raised from selling stock more efficiently, AVGO earned an additional \$5 from each \$100 stock sale.

3R Analysis Conclusion

Although both companies posted positive ROI, ROC and ROE ratios, shareholders make more money investing in AVGO stock instead of ADI stock. In addition to using its capital more efficiently, AVGO has an unusually low debt load which gives the company more available funds to invest. Using the 3Rs successfully identified which company gives you the greatest return for your investment dollar.

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