ROC vs. ROE

Let’s pretend we live in a world without taxes, just to make things simpler.

Year 1:  A start-up company raises $1,000,000 by issuing stock.  It uses the money to create a business that earns income of $100,000 a year.  Its return on equity = return on capital = 10%.  The firm reinvests all income into the business.

This is a pretty ho-hum business, returning 10% from operations.

Year 2:  Management then raises debt capital to supplement its equity by borrowing $900,000 from a bank at 5% interest.  It uses the extra funds to expand aggressively.

Let’s say it gets the same return as with its initial capital  Using the loan + retained profits from Year 1, it doubles the size of its business.  It earns $200,000 in income from operations  in Year 2 -$45,000 in interest expense = $155,000.

Its return on its total capital of $2 million, after deducting interest expense from operating income, drops, to 7.8%

Its return on equity of $1.1 million, however, rises,  to 14.1%.

The now financially-leveraged company posts 55% earnings growth, not 10%, and sports an above-average return on equity.

To the casual observer it now looks like a dynamo.   …but the transformation is all due to financial leverage.

Year 3:  Including income reinvested back into the business, the company now has $2,155,000 in capital, $1,255,000 of that in equity and $900,000 in debt.  It borrows another $900,000 on the same terms from its bank and puts that into the business.

The $3.055 million generates $305,500 in income from operations.  Interest on $1,800,000   @ 5% is $90,000.  Doing the subtraction, net earnings = $215,500.

Earnings growth is 39%+.  Return on equity is now 16%+.      Again, the difference between being the sleepy 10% grower and an apparent home run hitter is entirely due to management’s financial engineering.

 

What’s wrong with this picture?    In a bull market, nothing.  But the company has exposed itself to two financial risks if business slows.  Can it generate enough cash to pay the $90,000 in interest expense, which amounts to four months’ profits in good times but maybe ten months’ in bad?  Can the bank call part–or all–of the loan?  If so, how does our company get the money, which is the equivalent of nine years’ earnings?

 

stock buybacks:  more financial engineering

A second issue:  suppose the company employs another form of financial engineering and uses the money it borrows at the beginning of Year 3 to buy back stock rather than reinvest in the business.

Why do this?

…it doesn’t improve overall earnings, but boosts earnings per share.  Although framed in press releases as a “return” to shareholders, this also–one of my pet peeves–disguises/offsets the dilution of you and me as shareholders through the stock options management issues to itself.  (I’m not against stock options per se; I’m against the disguise.)  In this case, earnings are $215,500 before interest expense of $90,000.  Interest expense amounts to five months’ profits.  The loan principal is equal to 18 years’ earnings.

 

how/why does financial engineering like this happen?

When there’s lots of extra money sloshing around in the system, banks, the fixed income markets and companies do crazy things.  This was a potential worry several years ago.  Unfortunately, lacking understanding of how the economy or the financial system works, the Trump administration has made the problem worse through the tax and money policies it has pursued.  Instead of taking away the punch bowl, Trump has spiked it a lot more.

 

my take

For us as investors, the point of this post is to distinguish between companies that show high returns on equity because of the earning power of the company business (high returns on capital; these are keepers) from those where financial engineering is the main reason returns on equity are high (low returns on capital; riskier than they seem at first glance and likely to perform poorly in wobbly markets).