return on equity: a measure of management prowess

REITS  …eventually

I want to eventually write about the attractiveness of REITs and the increasing tendency of mature companies in the US to turn themselves–or at least part of themselves–into them.  This is the first in a series of posts to lay the foundation for that discussion.

a new company, a blank slate 

Imagine that we’re forming a new company.  On Day 1, the books and accounts of the new firm are just empty pages.

balance sheet

Then we inject some cash to get the firm going.  We get shares of stock, representing our ownership interest in the new firm, in exchange.  The balance sheet of the new firm will reflect this transaction by recording the cash inflow on the asset side, and the same value under “shareholders’ equity” on the other (the liabilities + equity side).

income statement

The new management of our company–maybe us, maybe professionals we’ve hired–invests the cash in (we hope) high-return projects that generate a lot of income.  We, or our accountants, will periodically create an income statement to record how much money we’ve earned (or lost) during a given period of time.  In real life, the money is coming in every day and being spent or invested almost simultaneously.

where the money goes

In the simplest conceptual terms, two things can happen to the money the firm earns.  It can be reinvested in the firm’s operations, in which case we can think of it as entering the balance sheet as cash (in + or – amounts) on the asset side (and then being invested in working capital or plant and equipment, which are other categories on the asset side) and as corresponding changes to shareholders’ equity on the other.  Or it can be paid out to shareholders as dividends.

If the firm makes a new stock offering to raise additional capital, the balance sheet activity will be similar to what happened at the firm’s birth:  cash is entered on the asset side of the balance sheet; shareholders’ equity rises by the same amount on the other.

One way of summarizing this process–the one we need today–is that shareholders’ equity represents the amount of money the management of our firm has to work with:  the initial capital, the proceeds from further equity issues, plus accumulated profits (minus any amounts paid out to shareholders).

measuring management’s skill

How do we measure management success?  One straightforward method, for both actual and potential shareholders, is to look at the income the firm produces with the money it has invested.  In other words:

—       annual profit  ÷  shareholders’ equity,    which is known as return on equity.

Astute readers will recognize that shareholders’ equity is also known as book value.  Regular readers may remember that I’m not particularly a fan of book value as a valuation metric.  True, but let’s put that aside for the moment.

return on equity

The virtue of using return on equity is its simplicity.  A return on equity of 3% a year is bad.   A return on equity of 15%+ is good.  In today’s world it’s very good.

stock market adjustment

For publicly traded companies, firms that consistently achieve only a 3% return on shareholders’ equity will probably trade at a huge discount to book value.  If Wall Street believes that a firm should be able to earn 10% a year on the money it has to work with, then the 3% company might trade at 1/3 of book (in reality, the market will likely expect either the company’s board of directors or an activist outsider to force a change of management.  So the discount won’t be as deep as it otherwise should be).

On the other hand, a firm that consistently earns 15% on equity will doubtless trade at a premium.

some caveats

Bad companies can sometimes have high returns on equity.  One of my favorite examples is Fotomat, which had kiosks in mall parking lots where it collected undeveloped camera film ad returned prints to customers the next day.  I remember a shareholder calling me up one day to criticize me about my negative view, citing the company’s current 15% return on equity.  I pointed out that the prior year the company had a mammoth loss, which cut its equity in half!!  Shrinking the denominator is not the best way to achieve good return numbers.

Suppose we invested $100/share in a gold exploration venture–and our geologists discover gold worth at least $1000/share.  The stock will trade at 5x, or 10x, or some higher x, book value–even though production hasn’t started (in fact, the Wall Street cliché is that the stock peaks the day the mine opens).  Other kinds of natural resource companies can experience this phenomenon, as well.

prisoners of the past?

If we imagine the assets of a company as being a collection of investment projects–some successful, some not–how do we deal with the clunkers?  In particular, what do we do  if we’ve just been hired to run a firm and see (from low historical returns on equity) that the company is filled with terrible past investment projects?  Or how do we keep the inevitable mistakes from tarnishing our record forever?

More tomorrow.

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