One of the most straightforward ways of evaluating how a company management is doing is by looking at the returns it achieves on the money it invests on behalf of shareholders. Like most things in finance, this starts out as a very simple task, but soon enough adds refinements that make the evaluation process look a lot more complex than it actually is.
We’ll start with return on equity.
A new company forms and sells 1000 shares to investors at $10 each, for a total of $10,000. It invests all of that money one January 1 of its first year.
During that year it earns $1000 in net income.
Its return on equity for year 1 is 10% ($1000/$10,000). At this point it has no long-term debt, so its return on capital (capital = equity plus long-term debt) is also 10%.
If the company pays no dividends, it now has $11,000 in equity (capital, too) at the beginning of year 2. To maintain a 10% return on equity (and capital) it must earn $1,100 in year 2.
The total amount of equity a company has to invest is also called “book value,” because it’s the value of the equity entry on the company’s financial records (books).
All other factors being equal, a company whose management achieves a high return on equity tends to trade at a premium to book value. One that continually produces sub-par returns tends to trade at a discount. The financial sector in particular, because it’s hard to figure out the tons of transactions that the big firms routinely execute, tends to trade on price to book.
Tomorrow, adding debt to the picture.