POP Quiz: Is a Rising ROE Good?

snowmen

I intend to live forever. So far, so good–Steven Wright

We will tackle Chapter 4 in Deep Value next week and I will find out the status of the forum for advanced students this weekend. I am swamped. 

POP QUIZ

If a company is increasing its Return on Equity (“ROE”) over time, is that an attribute of a good business?   

Since you are skeptical, you whip out your ROE diagrams:

400px-DuPontModelEng.svg

simpler

roe

Even better, you are hired as the investment banker to help advise the CEO how to enhance ROE (bonuses are based on rising ROE and increasing earnings per share).

Today, the company receives 0.00000000000001% on its money market accounts, while the CEO’s company stock trades at 34 times earnings and earns its cost of capital, 10%.   Remember, you work for JP Morgan and you have student (MBA) loans to pay off.  You sharpen your pencil and……………….?

My thoughts posted this weekend after I pass out grades.

Post: Feb. 16, 2015

Damn! I am unable to flunk anyone. There was a good discussion looking at the question from many sides because I didn’t give you much detail.  The key point is: “It depends.”  Context is key.  You could have a situation like Microsoft’s where its core businesses (Office, etc.) generate so much cash without incremental investment that cash builds up and in turn drags down ROE (equity grows without a high return on the cash). Then the issue becomes what will Microsoft do with its excess cash? Squander on new ventures and acquisitions or return it to shareholders?  Microsoft over the past six years has done a little bit of both. Perhaps low ROE means the company has no debt and thus a buffer during cyclical down turns?

Maybe this company’s ROE is suppressed by last year’s investment into new stores and more time is needed before the stores earn their expected return. Perhaps, like Costco or Philip Morris, future growth will be so profitable and persistent that buying in shares means reducing shares below intrinsic value–a long shot, how many emerging Wal-Marts, Costcos or Whole Foods are there?

The popular move which I, as a JP Morgan banker, would advise the CEO to buy back his stock with his low yielding cash (about a 0%) return and lather on low cost debt to buy stock back  to earn an approximate 3% return (1 divided by 34) despite being a mundane business (10% ROE). Even at inflated prices. You shrink share count and equity to drive up EPS and ROE. The CEO collects another bonus and you can chirp about your value enhancement strategies.  But when you buy an average company at 34 times earnings, you are paying over intrinsic value (let’s assume). Earnings and ROE rise but book value drops. Long-term wealth is reduced.   Look at tech and consumer good companies today where managements are buying in their stock near all-time highs after a six year run-up.  Few bought shares in the depths of the 2008/09 crisis.  Borrow money today at 3.5% to buy-in your stock at a 5% earnings yield. Brilliant–until the next economic downturn.

This is another lesson in incentives. CEOs are incentivized to get a short-term bump in their stock prices, long-term value be damned.

GOOD JOB to all who commented.

15 responses to “POP Quiz: Is a Rising ROE Good?

  1. To pay off my student loans, I’d recommend a share repurchase program to the CEO, financed by debt. This will reduce shares outstanding, which will improve EPS, and will reduce equity.
    Send out a splashy press release on the friday of a long weekend announcing a debt issuance or a structured commercial paper program for “general operational use”, or “working capital needs”.
    Send out a press release announcing a share repurchase program as a way to enhance value for shareholders on a Monday morning, a few weeks removed from the debt issue.

    With a P/E of 34, assuming no debt currently, the company will need 3.4 debt for every $1 equity reduction, which will add considerable leverage to the balance sheet, so it’s best to work gradually. Develop a 5 year record of EPS and ROE improvement. Meanwhile, visit CNBC regularly and talk up your operating enhancements.

  2. Seeings as I need to pay off my debts, I would recommend activities that generate fee income for me. So I’d recommend acquisitions, which I’d be happy to advise on. Paying with cheap money or with shares will work well, although cash is actually cheaper. If you’re giving out shares to pay for the acquisition, remember to buy a target company whose PE is less than 34. Borrowing money can actually reduce your cost of capital (up to a certain point).

    Acquisitions will add value if the purchase generates more than the cost of capital, but destroy it otherwise. Agency-principal problems will mean that this consideration is likely to be ignored by both me and the CEO. Analysts don’t seem to care much about it, either, just so long as they see a nicely growing EPS!

    Remember to tell the market that such acquisitions will be “immediately value-enhancing”, and always use the word “synergies”. I can’t stress that last part enough!

    I guess you try becoming more efficient operationally, but that requires real management skill, and I’m out of my depth on that one. I work for JP Morgan, not Anderson Consulting (as if they knew what they were doing anyway).

    Actually, disposal of crummy business segments can also enhance ROE.

  3. at such a high P/E you should probably issue shares and use the proceeds to buy higher ROE businesses at lower multiples

  4. I wouldn’t necessarily have to buy companies at higher ROE. Let’s say I have a ROE of 10%: 10 earnings on 100 equity. Suppose I want to acquire a company with 5 earnings on 100 book. It has a ROE of 5%.

    But look: suppose I borrow 100 to make the acquisition, i.e. at target’s book. I’m paying the target shareholders 20X PE. It still makes “sense” to me, because my post-acquisition earnings are 15, whilst the book value is still 100 (100 original book + 100 acquired book – 100 loan).

    As if by magic, I have raised my 10% ROE to 15% ROE. However, as a “firm”, I am worsening my return on capital. Ignoring taxes, my pre-acquisition ROC was 10%, and my post-acquisition ROC is 7.5% (15/200).

    • Actually, in your example ROE would be less than 15.When you borrow to make acquisition or share buy back your net income decrease by the amount of extra interest. Whether or not you increase ROE depends on the ratio of earnings yield and interest rate.

  5. +1 for geanoo’s response. Take on additional debt, buyback shares. Reduce shares outstanding, increase earnings per share, decreases shareholders equity, and increases ROE. Assuming price remains unchanged, the P/E gradually decreases and the buybacks appear more opportunistic and shareholder friendly.

    In my opinion, the added debt increases risk, which cancels out any growth. There’s a tipping point where the amount of debt puts the longterm prospects in jeopardy, decreasing value. Up to that point, in my opinion, the value of the company remains unchanged with addtional earnings added as a result of taking on additional debt.

  6. 1. Raise copious amounts of debt
    2. Massive share buybacks (using the debt)
    3. Acquire highly profitable businesses (using the debt)

    That should get you 80% of the way there, and then:

    4. Sell / spin off low return segments
    5. Delay capex for as long as possible
    6. Cut or delay SGA, R&D expenses wherever possible
    7. Sell assets (e.g. investments, land, real estate) to realize one time gain on sale
    8. License or franchise wherever possible

  7. If a company is increasing its Return on Equity (“ROE”) over time, is that an attribute of a good business?

    It depends on how the ROE is increasing. ROE can be manipulated by writing off assets, share repurchases, issuing debt to buy back stock, all lower equity and enhance it. Not sure about the technicalities but you can also move the company’s debt to other entities (like Enron did.) You can mess around with earnings.. mess with receivables and book them as sales quickly, do related party transactions, delay the payment of account payables, and other forms of debt. You can use these methods to enhance ROE.

    Acquisitions of good businesses at good prices and selling off crappy assets can also help increase ROE.

    You can pay off the loans by requesting compensation for making the stock price rise quickly.

    Or.. you can improve business performance by raising prices (if you can), cutting costs, and increasing asset turnover.

    Increasing ROE can be an attribute of a good busines if you understand why it’s rising and determine that it isn’t financial wizardry.

    Regards
    Simon

  8. I think you are all on the right track.

    Another idea may be to reduce asset values wherever possible but doing it in ways that produce only “one time” losses (which would normally be excluded by analysts from the net income calculations). For instance, announce a major restructuring and write-off as much PPE as possible. That improves the asset turnover calculation, and it takes out a lot of depreciation too so as to bolster reported net income in the future. (I wouldn’t go so far as having a negative balance for plant in the way that Mr Graham cheekily referred to in his famous memo about US Steel’s modern accounting system!)

    Alternatively, try sales & leasebacks of fixed assets, by way of operating leases only. If the new rental charges are reasonable, that can have a nice effect in terms of improving ROE.

    Think about adopting LIFO accounting for inventories too. (Not sure about this – I work in an IFRS environment, which requires FIFO, so my understanding of LIFO tricks is not what it should be!)

    Cheers,

  9. Capitalising as much as possible, as opposed to writing it off, also improve ROE.

    This is a bit of a problem with a lot of software companies in the UK, for example. Huge amounts of development costs are capitalised.

  10. To add:

    1) EPS can be increased just by re-investment (no matter a good business or a bad business)–>>’Most companies define “record” earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding.’ WEB BRK 1977
    2) Limitations on improving Margins and Turnover>> in capital intensive business its hard to improve or sustain high RoE; competition puts a cap on improving margins and turnover. (Although the situation is different for non capital intensive business, business possessing strong competitive advantage. But this business just earns 10% on capital so no competitive advantage)

  11. I like to use Dupont analysis when looking at ROE.

    ROE= profit margin(Profit/Sales)*Total asset Turnover(Sales/Assets)*Equity Multiplier(Assets/Equity)

    If you plug in numbers for a 10% ROE and double all your inputs to take into account a takeover or merger ROE does not necessarily increase.
    If there are some synergies i.e. Assets and Equity Double but sales and profit increase by more then ROE goes up.

    A takeover or merger that reduces overall equity or shares outstanding will also increase ROE. Given the high P/E it makes more sense to use the candidate company’s stock to exchange for another company with a comparable or higher ROE.

    We are not given the capital structure of our candidate company. If it has no debt obviously borrowing to retire shares will increase the ROE. If the company generates free cash flow this can be used to buy back shares to increase the ROE. Not recommended as with the high Price to Earnings you will surely be paying over intrinsic value for each share.

    From a bean counter perspective and operating efficiency the best way to increase ROE is to increase your profit margin or asset turnover.

    An increase in ROE is not always an attribute of a good business:

    If Book Value goes down ROE goes up.
    A company can keep adding debt to the point of having too onerous future interest payments to boost it’s present day ROE.

    Profit margins are increased by cost cutting, reviewing and possibly increasing selling prices, taking supplier discounts, introducing more efficient inventory management.

    I will seriously review the asset turnover at the candidate company.
    The turnover ratio could be dragged down by poor inventory management and lax collection methods. If the business is in decline you may have to sell off some assets in anticipation of declining production or sales.

  12. As to the first question, rising ROE in neither necessarily bad or good; it just depends what is happening with the firm and its market and its balance sheet. Rising leverage (i.e. selling debt) while reducing equity can be bad. Investing to get the last customer at the margin can be good even as ROE goes down. On the other hand, improving operating income at a cost greater than capital can be bad, etc.

    mcturra: Technically, in the US according to GAAP you can not capitalize R&D and in any case making it an asset (capitalizing it) may not necessarily affect the ROE beneficially. You could be increasing the Equity. Although you can do other things in the US that basically capitalizes the D of the R and D, etc.

    Ayush, remember the CEO is also paid for raising the ROE, so just increasing earnings does not help him or her when invested in a bad business, even if it helps my bonus.

    As a general rule you can approach the ROE from the balance sheet or the income side.

    Remembering that one year of Wall Street bonus will pay for all of undergrad student debt, my incentive is really to climb up in the bank not per se to pay off my debts. But my client is the CEO not the firm or the shareholders…

    So echoing the other comments I would advise.

    1. Reducing equity via increased leverage and moving lower performing assets off the balance sheet. So if there is any property that my firm can sell, off it goes, etc.I don’t make any money on vanilla spinoffs so I need to get this sold to an acquirer or something fancy.

    2. Increase debt in the firm to buy back stock, to a level that is prudent for my bonus, I mean for the CEO, I mean for the company…The debt will increase the risk to the firm, and the PE implies a 3% return on buyback but that is what my client wants.

    3. Using stock to buy other companies such that it is accretive to ROE and per share earning is really good for my bonus and the CEO gets to build an empire.(This is a little too snide, Great capital allocators, like Singleton of Teledyne used stock like this to great effect!)

    4. As an investment banker, I don’t have as much impact on the income statement, but I can recommend calling in some of my buddies from who are consultants, who will suggest reducing the R&D, but not the corporate jet.

  13. The answer has to be “it depends”. If ROE is rising through genuine Net Proft growth this is good. If it is rising through borrowing money to buy back shares and reduce equity, this is unsustainable ROE growth and limited by debt being taken on and has a change in risk to the issue. Remind me why did Buffett invest in IBM again outside of his defined circle of competence? Because of their 5 year plan for EPS growth (using financial engineering?). Not necessarily a mistake by Buffett, but at risk of a Minsky moment and lets face it IBM a very corporate slow moving culture. Interesting.

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