return on equity vs. return on capital: why this matters today more than usual

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).

 

 

 

 

 

 

evaluating management: Donald Trump and real estate

Last year Forbes published an analysis by James Elkins, a professor in the finance department at the University of Texas, that concludes Mr. Trump has underperformed the average real estate professional in the US by a whopping 57% over his career, despite the boost to returns he achieved by maintaining almost twice the average amount of financial leverage.

The results are highly tentative.  Prof. Elkins uses a REIT index as a proxy for overall real estate returns.  He also employs Mr. Trump’s statement of his starting net worth and the Forbes $4.5 billion estimate of his 2016 wealth (the 2017 estimate is $1 billion lower).

On the industry benchmark, my experience with real estate moguls, mostly outside the US, is that the returns on their private real estate investments are generally higher than those they achieve in their publicly traded vehicles.  In Mr. Trump’s case, his net worth also includes his considerable earnings as a reality show star, as well as the potentially positive effect of debt forgiveness through bankruptcies.

In short, the 14.4% annual return on equity Elkins uses for the industry is probably too low and the 12.5% return he figures for Trump is too high.

 

My question is what the returns on capital are in the Elkins example.

According to Elkins, REITs have an average debt to equity ratio of about 30%.  This means they have a mix of roughly three parts equity, one part debt.  Assume that their average cost of debt has been 8%–a figure that seems reasonable to me but which I’ve just plucked out of the air.  If so, their 14.4% return breaks out into roughly a 12.5% return on capital (actually operating real estate ventures) and 2% from using financial leverage.

This calculation implies that Mr. Trump’s 12.5% return breaks out to something like 9% from real estate and 3.5% from financial leverage.

At first glance, the difference between a 14.4% annual return and a 12.5% return doesn’t seem like much.  Prof. Elkins’ point is that over a career being a relative laggard adds up.  In this case, it translates into having $4.5 billion instead of $23 billion.  Mine is that the numbers flatter Mr. Trump’s planning and management skills, which fall even more deeply below the average in the real estate industry than his overall results.

(5/20/19. Note:  the consensus today is that Mr. Trump never had assets anywhere near the Forbes figure and that in real estate, he added no value–doing little more than preserve in real terms the capital he inherited from his family.  That is, the idea that he made a fifth of the return of the average real estate magnate–and perhaps a tenth of what the best did, is too generous.  He appears to have made nothing.  Even so, that’s without factoring in the personal lifeline he may have received from security holders of his ill-fated Atlantic City casinos.

Together with the tax returns published by the New York Times, the picture that emerges is of a brilliant self-marketer, who has been able to recast the reality of a singularly maladroit businessperson.  Again, even this assessment may prove too flattering, if there is any substance to the money laundering allegations that are now surfacing.

One more thing:  I’ve taken a second look at my return calculations and revised them slightly.  None of my conclusions change:  Mr. Trump’s performance comes out slightly worse than before.)

 

 

evaluating management: issues with financial leverage

Given the possibility to boost return on equity substantially, why is it that every publicly traded corporation doesn’t make extensive use of financial leverage?

Several reasons:

–as I mentioned in my initial post, in some areas of the world investors think using debt capital is a bad thing, either because they believe debt is unethical or (incorrectly, in my American view) that debt is more expensive than equity

Philosophy aside, having debt on the balance sheet has risks:

–debt service (interest and principal repayments) is an immediate subtraction from operating cash flow.  If a company takes on excessive debt, if it makes a mistake in capital deployment, or if it is particularly sensitive to the ups and downs of the business cycle, debt service can become a burden.  In extreme cases, debt holders may have the right to accelerate the repayment schedule, restrict company operations–or even take over management of the firm through bankruptcy proceedings

–having a large amount of debt can hamper a firm’s ability to respond to a changing competitive environment.  Macy’s failure to build an effective online retail presence, for instance, has been attributed to its need to devote large amounts of operating cash flow to debt service.

In addition, Wall Street investors tend to believe (correctly, I think) that it doesn’t take much skill to float a bond issue or get a bank loan.  It’s much harder to employ capital well in running operations.  So while investors may want the extra returns that a leveraged company can achieve, they will pay a much higher price for returns on capital than for returns on leverage.

evaluating management: return on capital

equity capital

Yesterday, I wrote about return on equity, as it applies to a company that uses only this form of capital, i.e., has no long-term borrowings, no financial leverage.

debt capital

In most places, companies are allowed to employ debt capital in their long-term operating plans as well as equity.

Opinions differ as to whether this is a good idea or not.  Americans tend to approve, on the idea that debt is a cheaper form of capital than equity; investors in the UK and Europe tend to disapprove–arguing that debt is a more expensive form of capital than equity.  In the Islamic world straight debt is not allowed.

My chief comment is old saw that “leverage works both ways;”  that is, during an economic expansion it’s most often a return booster, while in bad times it can be an albatross around the firm’s neck.

example

Let’s say a company goes public by selling 1000 shares at $10 each.

Once it’s public, it issues $10,000 worth of ten-year bonds with a 5% coupon.

Now it has $10,000 in equity and $10,000 in debt.

Let’s say it invests all the money in projects that produce a $2000 annual return. (For simplicity’s sake, let’s make the (unrealistic) assumption that the money is all raised and invested in projects that are instantly up and running on January 1st).  Let’s also ignore taxes.)

At the end of year 1, the firm has earned $2000.

return on capital

Its return on capital is:  $2000 ÷ ($10,000 debt + $10,000 equity = $20,000), or 10%.

return on equity

Its return on equity is:  ($2000 – $500 in interest = $1500) ÷ $10,000 equity  = 15%.

return on leverage

Let’s define another term, return on leverage, as the return on equity minus the return on capital.  In this case, the return (to equityholders) on (or from) leverage is +5%.

Why do so?   Why in the form of a simple subtraction?

As to the form, the sole reason is because it is a simple thing to figure out.

I think it’s important to break down the returns a management is producing for shareholders into two components to quqntify how good it is at two different management skills–how company operations are being run (return on capital) and how those returns are being supplemented by shrewd use of debt financing (return on leverage).

I say “supplemented” because in a well-managed business the lion’s share of the returns will come from operations.  Returns from leverage will be the icing on the cake.

Looked at in a different way, what conclusion should we draw if most of the returns come from leverage?  One worry is that the firm’s management doesn’t have the necessary operating skills to be successful and is substituting aggressive risk taking with company financing to cover up for this deficiency.

For example:

Suppose the company described above earns $1200 in year 1.

That’s a 6% return on capital.

The return on equity is ($1200 – $500) ÷ $10,000 = 7%.

The return on leverage = 1%!  This is trouble, because the company is barely covering the cost of its borrowing.

A worse case:

The company earns $400.

The return on capital is 2.5%.

The return on equity is ($400 -$500) ÷ $10,000 = -1%

The return on leverage is -1% -2.5% = -3.5%.  This is a disaster.

 

More tomorrow.

 

 

evaluating management: returns

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.

initial 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%.

equity grows

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.

book value

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.

Snap (SNAP) non-voting shares (iii)

forms of capital

Traditional financial theory separates a company’s long-term capital into two types:

–debt capital.  This is money the firm has borrowed, either through bank loans or company-issued bonds.  Creditors may have influence over company operations through restrictions spelled out in the loan documents, called covenants.  They generally specify measures to accelerate loan repayment that the company must take if it fails to meet stipulated profit or cash flow measures.  (An example:  the firm may be forced to devote all cash flow to loan repayment if profits decline sharply.  Money can’t be spent on things like capital improvements or dividends unless creditors give the ok.)

–equity capital.  Equity means ownership.  Common stock ownership is typically established by the means equity owners have to assert/protect their interests–usually the ability to vote on appointment of members of the firm’s board of directors.  The board, in turn, hires and evaluates management.

Some companies may also issue preferred stock.   Preferreds qualify for their name because they have some advantage, or preference, over common.  The typical preferences are: higher/more secured dividend payment; and/or priority over common equity in liquidation proceedings.  On the other hand, preferreds typically either have restricted/no voting rights.  In the US, preferreds, despite the equity in their name, typically trade as if they were a form of corporate debt.

SNAP non-voting shares

Where do the SNAP shares fit in this scheme?

They’re clearly not debt    …but are they equity?

They are certainly not traditional equity.  They have no ability to exercise any influence on company operations, and certainly no way to replace an underperforming board of directors.  On the other hand, they don’t appear to have any of the greater security of preferreds.  In fact, they seem to be a hybrid that combines the riskier features of both.

The closest I can come, in my past experience, to US non-voting shares like SNAP’s (or Google’s for that matter) are Korean preferreds and Italian certificates of participation.  In both cases, they traded well in up markets but underperformed very signficantly during market declines.

 

value investing and mergers/acquisitions

buy vs. build

When any company is figuring out how it should grow its existing businesses and potentially expand into other areas, it faces the classic “buy or build” problem.  That is to say, it has to decide whether it’s more profitable to use its money to create the new enterprise from the ground up, or whether it’s better to acquire a complementary firm that already has the intellectual property and market presence that our company covets.

There are pluses and minuses to either approach. Build-your-own takes more time.  The  buy-it route is faster, but invariably involves purchasing a firm that’s only available because it has been consigned to the stock market bargain basement because of perceived operational flaws.  Sometimes, acquirers learn to their sorrow that the target they have just bought is like a movie set, something that looks ok from the outside but is only a veneer.

when the urge is greatest

Companies feel the buy/build expansion urge the most keenly at times like today, when they are flush with cash after years of rising profits.

so why isn’t value doing better?

Many economists are explaining the apparent current lack of capital spending by companies by arguing that firms are opting in very large numbers to buy rather than to build.

The beneficiaries of such a universal impulse should be value investors, who specialize in holding slightly broken companies that are trading at large discounts to (what value investors hope is) their intrinsic value.  Growth investors, on the other hand, typically hold the strong-growing companies with high PE stocks who do the acquiring.

On the announcement of a bid, the target company typically goes up.  The bidder’s stock, on the other hand, usually goes down.  That’s partly because the bid is a surprise, partly because the target is perceived to be priced too high, partly simply because of arbitrage activity.

All this leads up to my point.

Over the past couple of years, growth investing has done very well.  Value has lagged badly.  How can this be if merger/acquisition activity continues to be large enough that it is making a significant dent in global capital spending?