Return on equity – just how dependent is income upon equity?

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Virus4762
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Return on equity – just how dependent is income upon equity?

Post by Virus4762 » Mon Mar 19, 2018 1:24 am

Obviously, return on equity is relevant but I’m just trying to get a gauge on exactly how relevant it is. How would it factor in the following example (when comparing the strength of the following two companies):

Say there were two companies that were totally identical in every way – the only difference being the amount of equity, assets, and liabilities of each company.

Company A had assets of $2,000,000, liabilities of $1,000,000, equity of $1,000,000, and an income of $100,000 for the year and company B had assets of $200,000, liabilities of $100,000, equity of $100,000, and an income of $100,000 for the year.

Obviously, for the year, company A had an ROE of only 10% whereas company B had an ROE of 100%. Which would you consider the superior company? Company A’s equity is now 5.5 times greater than that of company B’s (1.1M vs .2M) but would company B’s greater ROE for the year be indicative of their ability to generate greater future income (as opposed to being nothing more than a misleading variable created by the company’s unusually low equity)? Basically, if you just saw these two numbers (the equity and income amounts of the 2 companies for the past year), and nothing more (work with me here), could it be presumed in any way that company B would generate greater income than company A in the following year (basically, would it be reasonable to assume that company B could potentially again pull of an ROE in the neighborhood 100%)?

Thanks
Last edited by Virus4762 on Wed Mar 21, 2018 2:30 am, edited 1 time in total.

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Sandtrap
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Re: Return on equity – just how dependent is income upon equity?

Post by Sandtrap » Mon Mar 19, 2018 1:41 am

Not so simple.
One is highly leveraged to bring in that ROI, the other, not so much.
Thus, one is more able to withstand the flip side of those returns, meaning downturns, because it is less leveraged, and vs vs.
Would one want to invest in a highly volatile company with high returns or a less volatile one with steady returns?
But, again. It's not so simple. Like taking a snapshot of an elephant's tail without seeing the rest.
j :D

Virus4762
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Re: Return on equity – just how dependent is income upon equity?

Post by Virus4762 » Wed Mar 21, 2018 2:23 am

Sandtrap wrote:
Mon Mar 19, 2018 1:41 am
Not so simple.
One is highly leveraged to bring in that ROI, the other, not so much.
My mistake - I did say "If the two companies were the same in every way except NI and equity" - I should have added assets and liabilities to that list too.

So if company A had assets of $2,000,000, liabilities of $1,000,000, and equity of $1,000,000 and company B had assets of $200,000, liabilities of $100,000, and equity of $100,000...how would each company's respective future outlook look then?

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Sandtrap
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Re: Return on equity – just how dependent is income upon equity?

Post by Sandtrap » Wed Mar 21, 2018 10:05 am

Virus4762 wrote:
Wed Mar 21, 2018 2:23 am
Sandtrap wrote:
Mon Mar 19, 2018 1:41 am
Not so simple.
One is highly leveraged to bring in that ROI, the other, not so much.
My mistake - I did say "If the two companies were the same in every way except NI and equity" - I should have added assets and liabilities to that list too.

So if company A had assets of $2,000,000, liabilities of $1,000,000, and equity of $1,000,000 and company B had assets of $200,000, liabilities of $100,000, and equity of $100,000...how would each company's respective future outlook look then?
Tough one.
At that point it's time to meet the owners and staff and tour the facilities, and watch daily operations in person.
Some businesses look great on paper.. . . .
j :D

JBTX
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Re: Return on equity – just how dependent is income upon equity?

Post by JBTX » Wed Mar 21, 2018 10:22 am

The companies can’t be the same in every way. If one has 2 million in assets and one has $200k, what are the assets for? Presumably working capital and fixed assets are there to help generate more business and profits.

I think you are trying to compare an aging work horse to a unicorn here. What sort of company generates $100k on 100k of net equity? I seriously doubt that ever happens. If you are making 100% return on equity why are you not expanding the business? All of their equity was derived in the last year.

All else equal, a higher ROE is better. But the higher the debt ratio, the riskier the business. Suppose a company A has 2 milllion in assets and $1.5 million in debt, generating $100 in income? That is 20% return on equity which is good, but it is highly leveraged and an economic downturn could drive it underwater.

Also depends on the nature of the assets. While accounts receivable is a good asset, if you have too much and some of it is aging then part of it may not be recoverable. Also goodwill, typically acquired via acquisition. It is really hard to measure the value of this asset, but it isn’t likely something that has short term tangible value in an economic downturn.

Financial ratios can be helpful, but they have limited value. They can be manipulated to some degree and you really have to understand the business to understand the quality and nature of the F/S number.

Take the time to read notes to the F/S. And if they aren’t audited realize they could be junk.

Virus4762
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Re: Return on equity – just how dependent is income upon equity?

Post by Virus4762 » Thu Mar 22, 2018 12:39 am

JBTX wrote:
Wed Mar 21, 2018 10:22 am
What sort of company generates $100k on 100k of net equity? I seriously doubt that ever happens. If you are making 100% return on equity why are you not expanding the business? All of their equity was derived in the last year.
I guess that’s what I’m asking – so the 100% ROE would, indeed, be indicative of expansion (greater income generating potential in the future)? Well, unless the reason for the unusually high ROE was because the company greatly increased its margins for one year to the next. Take AMZN for example. Their yearly net margins are extremely low (as is their equity, unsurprisingly) but if they arbitrarily decided to cut their R&D and SG&A spending in half next year, their profit for next year would be ~$30 billion – which is greater than their current equity. Given that their equity would in essence double at that point, what could reasonably be expected for the following year? Or would their income for the following year be totally dependent on the amount of their assets? I guess that’s the issue here – I’ve been asking about ROE but it sounds like maybe my previous assumptions are incorrect. Is net income dependent on the amount of assets a company has and therefore only indirectly dependent on their equity – or is it a mix of the two and I’m just being too nitpicky here?
JBTX wrote:
Wed Mar 21, 2018 10:22 am
If one has 2 million in assets and one has $200k, what are the assets for? Presumably working capital and fixed assets are there to help generate more business and profits.
Right. So the company with the 10% ROE would have a 5% ROA and the company with 100% ROE would have 50% ROA – so ostensibly the first company would be “inefficient” which, to be honest, is something I’ve never totally understood. I understand how assets are vital to the life of a company PP&E and the sort – but would an increase in assets necessarily indicate higher future net income? Take a company like Google for instance – obviously their core assets are vital to their business but how would a gain in any future assets help the company generate additional income. I know that sounds like a really stupid thing to say but a majority of that company’s (Google’s) income comes from advertisements (“clicks”) which makes it very hard for me to understand how and increase in assets would help generate future income.

I didn’t mean to write so much but I guess I’m more confused than I though – would really appreciate a response. Thanks a lot.

Valuethinker
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Re: Return on equity – just how dependent is income upon equity?

Post by Valuethinker » Thu Mar 22, 2018 6:08 am

Virus4762 wrote:
Mon Mar 19, 2018 1:24 am
Obviously, return on equity is relevant but I’m just trying to get a gauge on exactly how relevant it is. How would it factor in the following example (when comparing the strength of the following two companies):

Say there were two companies that were totally identical in every way – the only difference being the amount of equity, assets, and liabilities of each company.

Company A had assets of $2,000,000, liabilities of $1,000,000, equity of $1,000,000, and an income of $100,000 for the year and company B had assets of $200,000, liabilities of $100,000, equity of $100,000, and an income of $100,000 for the year.

Obviously, for the year, company A had an ROE of only 10% whereas company B had an ROE of 100%. Which would you consider the superior company? Company A’s equity is now 5.5 times greater than that of company B’s (1.1M vs .2M) but would company B’s greater ROE for the year be indicative of their ability to generate greater future income (as opposed to being nothing more than a misleading variable created by the company’s unusually low equity)? Basically, if you just saw these two numbers (the equity and income amounts of the 2 companies for the past year), and nothing more (work with me here), could it be presumed in any way that company B would generate greater income than company A in the following year (basically, would it be reasonable to assume that company B could potentially again pull of an ROE in the neighborhood 100%)?

Thanks
The distinction here is between equity and assets where assets = creditors (liabilities) + equity

If you are a financial institution, then cutting equity (share buybacks) and increasing liabilities (deposits, money markets, bonds) makes sense. You increase ROE = Net Income/ Equity. Bankers are basically rewarded for ROE.

If we look at Morgan Stanley v. Goldman Sachs in recent times, the latter has historically had a much higher ROE but is now struggling due to the fall off in revenues from trading. MS is a more conservative business, anchored in a huge Private Wealth Management business. Lower ROE, but now actually outperforming GS.

It's not so much how much assets they have, but how they deploy them-- the funding side of the balance sheet determines ROE. The less equity, the faster you are turning the wheel, as company management.

The analogy I make is to width of bicycle tires. In a financial institution, the more equity you have the wider the tires. You have more rolling resistance and you travel slower, but you are safer when you hit a pothole. Narrow enough tires and you will blow out on a pothole, and be finished. Lehman was leveraged (Total Assets/ Equity) nearly 40:1. By contrast Berkshire Hathaway has a far lower leverage (I'd have to check) on its insurance operations (although it looks to me like Reinsurance has nearly infinite leverage, but I may not understand it properly).

Buffett also understands liquidity risk-- how liquid your assets are (and how long term your liabilities are)-- whereas most people got that wrong in the leadup to the Great Financial Crisis. To be fair, managements get pounded for holding too much cash- -hence Citigroup's stock buybacks at what, 4x the current share price (10x the all time low post Crash?)? Companies are very good at retiring equity at the wrong time, unfortunately. *

Over to non financial companies. It's the Return on Assets that matters. In the example above one co is making 50% ROA and one is making 10% ROA-- you'd rather own the first one, generally. Although you'd want to understand sustainability, size of market niche, growth prospects, competitive threats.

Net Income/ Assets = NI/ Sales x Sales/Assets that's one version of the Dupont Formula.

ROA = Net margin x Asset turnover

We don't know the Sales of the company from your example, but my guess is they make way higher net margins.

* tech companies, which tend still to be controlled by Founders, are pretty good at holding a lot of liquidity. Maybe Apple's is excessive, but I watched RIM/ Blackberry burn through a $5bn cash pile in record speed when things turned down. Also of course the big cash piles are in companies which are famously cash generative- -Apple, Microsoft, Alphabet, Facebook etc.

Valuethinker
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Re: Return on equity – just how dependent is income upon equity?

Post by Valuethinker » Thu Mar 22, 2018 6:16 am

Virus4762 wrote:
Thu Mar 22, 2018 12:39 am
JBTX wrote:
Wed Mar 21, 2018 10:22 am
What sort of company generates $100k on 100k of net equity? I seriously doubt that ever happens. If you are making 100% return on equity why are you not expanding the business? All of their equity was derived in the last year.
I guess that’s what I’m asking – so the 100% ROE would, indeed, be indicative of expansion (greater income generating potential in the future)? Well, unless the reason for the unusually high ROE was because the company greatly increased its margins for one year to the next. Take AMZN for example. Their yearly net margins are extremely low (as is their equity, unsurprisingly) but if they arbitrarily decided to cut their R&D and SG&A spending in half next year, their profit for next year would be ~$30 billion – which is greater than their current equity. Given that their equity would in essence double at that point, what could reasonably be expected for the following year? Or would their income for the following year be totally dependent on the amount of their assets? I guess that’s the issue here – I’ve been asking about ROE but it sounds like maybe my previous assumptions are incorrect. Is net income dependent on the amount of assets a company has and therefore only indirectly dependent on their equity – or is it a mix of the two and I’m just being too nitpicky here?
Stick with Return on Assets. Or look at Return on Capital Employed (CE = equity + long term debt). ROE is really mostly relevant for financial cos (Banks and Insurers).

It doesn't matter how you finance your assets, it just matters how much of them you have. Caveat: if you borrow money, it increases your interest bill but lowers your tax bill. Therefore it's cheaper to fund a business by debt rather than equity, until the point of near bankruptcy.
JBTX wrote:
Wed Mar 21, 2018 10:22 am
If one has 2 million in assets and one has $200k, what are the assets for? Presumably working capital and fixed assets are there to help generate more business and profits.
Right. So the company with the 10% ROE would have a 5% ROA and the company with 100% ROE would have 50% ROA – so ostensibly the first company would be “inefficient” which, to be honest, is something I’ve never totally understood. I understand how assets are vital to the life of a company PP&E and the sort – but would an increase in assets necessarily indicate higher future net income? Take a company like Google for instance – obviously their core assets are vital to their business but how would a gain in any future assets help the company generate additional income. I know that sounds like a really stupid thing to say but a majority of that company’s (Google’s) income comes from advertisements (“clicks”) which makes it very hard for me to understand how and increase in assets would help generate future income.

I didn’t mean to write so much but I guess I’m more confused than I though – would really appreciate a response. Thanks a lot.
[/quote]

You have to estimate marginal return on new investment (net new investment = capex - depreciation (assuming no asset disposals)).

What is the incremental return for these companies of another dollar of capital spending? Probably for most tech companies it is now falling. The emphasis on disruptive innovation, which leads Facebook to pay $24bn for WhatsAp (with no real revenues, just costs) is an example. That's not going to look pretty in accounting terms-- even if it is a strategic necessity.

For Google it's a necessity to buy more servers. They are hugely capital intensive. Ditto Facebook. And setting up a new data centre somewhere which is cool and has cheap electricity (NE of Washington State for example has 2.5 c/ kwhr) improves your efficiency and thus your profitability. So does installing fibre backbone between your centres, thus bypassing the telcos.

However accounting rules make it difficult to capitalize intangibles (which would then be amortized or impaired, rather than depreciated or impaired as for tangible fixed assets). They tend to get expensed. Therefore arguably intangible assets like intellectual property, software etc. are undermeasured (that's certainly more true of US GAAP than IFRS).

That would tend to raise ROA in the long run- the accounting rules are not properly recognizing the real assets of the business. Think Apple-- it doesn't make anything (that's outsourced) but it has a market position and huge software library, lock in on Aps etc.

JBTX
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Re: Return on equity – just how dependent is income upon equity?

Post by JBTX » Thu Mar 22, 2018 7:33 am

Virus4762 wrote:
Thu Mar 22, 2018 12:39 am
JBTX wrote:
Wed Mar 21, 2018 10:22 am
What sort of company generates $100k on 100k of net equity? I seriously doubt that ever happens. If you are making 100% return on equity why are you not expanding the business? All of their equity was derived in the last year.
I guess that’s what I’m asking – so the 100% ROE would, indeed, be indicative of expansion (greater income generating potential in the future)? Well, unless the reason for the unusually high ROE was because the company greatly increased its margins for one year to the next. Take AMZN for example. Their yearly net margins are extremely low (as is their equity, unsurprisingly) but if they arbitrarily decided to cut their R&D and SG&A spending in half next year, their profit for next year would be ~$30 billion – which is greater than their current equity. Given that their equity would in essence double at that point, what could reasonably be expected for the following year? Or would their income for the following year be totally dependent on the amount of their assets? I guess that’s the issue here – I’ve been asking about ROE but it sounds like maybe my previous assumptions are incorrect. Is net income dependent on the amount of assets a company has and therefore only indirectly dependent on their equity – or is it a mix of the two and I’m just being too nitpicky here?
JBTX wrote:
Wed Mar 21, 2018 10:22 am
If one has 2 million in assets and one has $200k, what are the assets for? Presumably working capital and fixed assets are there to help generate more business and profits.
Right. So the company with the 10% ROE would have a 5% ROA and the company with 100% ROE would have 50% ROA – so ostensibly the first company would be “inefficient” which, to be honest, is something I’ve never totally understood. I understand how assets are vital to the life of a company PP&E and the sort – but would an increase in assets necessarily indicate higher future net income? Take a company like Google for instance – obviously their core assets are vital to their business but how would a gain in any future assets help the company generate additional income. I know that sounds like a really stupid thing to say but a majority of that company’s (Google’s) income comes from advertisements (“clicks”) which makes it very hard for me to understand how and increase in assets would help generate future income.

I didn’t mean to write so much but I guess I’m more confused than I though – would really appreciate a response. Thanks a lot.
I think you are trying to get too much out of the numbers. In general higher ROE is better. But not always. If a drug company slashes research and development, their income and roe will go up, but a few years down the road their growth will stall and income will go back down as they have no new drugs. Amazon is kind of the same way. They are plowing their profits into growth. They could stop doing that and become more profitable but their long term growth and long term profitability would likely suffer. In general assets are acquired to facilitate growth, but their mere existence doesn’t guarantee growth. Old receivables, outdated plant and equipment and goodwill don’t necessarily help growth. They may actually hurt profitability.

Not only do you have to know the numbers but what is in them.

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