- ROE is a important indicators
of a firm’s profitability and potential growth
- There are some pitfalls of using ROE for measuremen - ROE can be increased with debt.
- ROIC corrects ROE's problem - looks at all moneys (by shareholder and lender) invested into company and how much profit the management can generate.
- It is arguably the best
way to determine if a company has a moat.
- Investor focused on earnings growth and not ROIC would miss the fact that the earning growth was generated by how much capital (include debt).
- It is very useful as comparisons among
companies within sectors. Highest ROIC = making more profits from every dollar invested - often show the biggest share price gain (shown by Joel Greenblatt's Magic Formula)
- Formula
-
ROIC = NOPAT / Invested Capital
- NOPAT =
Net Operating Profit After Tax = Operating Income * (1 – Tax Rate)
- !!! Operating Profit (aka EBIT) - not include
items such as investments in other firms, taxes, interest expenses and other
nonrecurring items
- Invested Capital = Total equity and equity equivalent + total
debt – excess cash and investments
- Excess cash - cash of a company has that is not required to operate the
business. (1) interest income is not part of Operating Income (2) if company with significant cash balance - the divided result might yield too low
- or, we take the total asset and minus out non interest bearing liabilities
Invested Capital = Total Asset - Non Interest bearing current liabilities - Excess Cash
- =Fixed Assets + Current Assets – Non-interest bearing Current Liabilities
– Excess Cash
- = Fixed Assets + Non-cash Working Capital
- Non Interest bearing current liabilities - account payable (it is capital invested in the business by a company’s suppliers or contractors, not
the company itself), deffered revenue and deffered tax.
- Long term investment - it is not operating assets and should be excluded
- Some people deduct goodwill from total assets as it is financial capital, not operating capital. If we do so, the amortization of goodwill need to add back to operating income.
- Use of ROIC
- If company ROIC > 15% for number of years - it most likely has a moat.
- But a positive spread between ROIC and WACC alone doesn't justify an
economic moat. Investors also have to think about the qualitative
attributes--high barriers to entry, huge market share, low-cost production,
corporate culture, patents, or high customer switching costs--that create an
economic moat around a company's profits.
- Compare the
efficiencies of companies using ROIC in the same industry to determine which is
a better one to invest in.
- ROIC can also be compared to the firm’s cost of capital
to conclude whether the firm has collectively invested in good projects. - A company creates value only if its ROIC is higher than itsWACC.
- Cost of Capital
- When company raise capital from owners or lenders, the investor require a return on their investment.
- Stable and predictable company will have a low cost of capital,
while a risky company with unpredictable cash flows will have a higher cost of
capital.
- Weighted
average cost of capital (WACC) - all capital sources - common stock, preferred
stock if any, bonds and any other debt - are included the calculation.
- WACC = E/V * Re + D/V * Rd * (1 -Tc)
- E = Market Value of Equity
- D = Market \ Book Value of Debt
- V = Total Value of Firm = E + D
- Re = Required return of equity holders
- Rd = Required return of debt holders
- Tc = Tax rate (cost of debt is tax deductible)
- Cash-on-cash returns are what we're looking for in calculating ROIC. We're trying to look past distortions that come from accounting conventions. Accounting is a rules-based system that allows for a number of choices that can be made by financial managers and approved by auditing firms and distort a company's true economic earnings.
References:-
- Cash Conversion Cycle (CCC)
- CCC = Days Inventory Outstanding + Days Sales Outstanding – Days Payables Outstanding
- It measure of management effectiveness on cash management. How efficiently the business turn cash over. The lower the better.
- CCC is a relative number. It need to compare with historical average and competitor's figure to determine whether it’s good or not.
- CCC with decreasing trend is peferable.
- Need to be cautious with bing increase - possible cash shortage and inventory issues.
- Cash Return on Invested Capital (CROIC)
- CROIC = FCF / Invested Capital
- Invested Capital = Shareholders Equity + Interest Bearing Debt + Short Term Debt + Long Term Debt
- The numerator can interchange with owner earnings - depending on the company and situation.
- CROIC is a lumpy figure and it is not going to be flat line. We need to look for some levels of consistency.
- CROIC > 13% consistently is a sign of moat - mean FCF is +ve and the business is a strong performer in the industry.
- EV/EBIT
- EV/EBIT = Enterprise Value / Earning before Interest and Tax
- Buffett’s rule of thumb is to pay 10x pretax when acquiring businesses.
- FCF to Sales
- FCF to Sales = FCF / Sales
- What percentage of sales is converted directly to FCF. - The higher the better
- Any company hash FCF to Sales > 10% is a FCF generating machine.
- FCF to Short Term Debt
- Whether the company can cover it’s short term debt with FCF. Not by borrowing or diluting, but with internally generated funds.
- < 1, the company doesn't generate enough FCF to cover its debt. If the ratio consistently < 1, there is a high change of trouble.
- > 1, the debt can be covered without borrow more.
- Inventory Turnover
- Inventory Turnover = COGS / Average Inventory
- Measure how quickly company sell it inventory
- The goal is to quickly turn inventory into cash, then reinvest the cash
back into inventory, and then turn it to cash again for even more
profits.
- Compare inventory turn over with similiar companies.
- High inventory turnover can be achieved via
- Tight inventory management (excellent)
- Reducing price to quicky sell (bad)
- Magic Formula Yield
- Magic Formula Yield = EBIT/EV
- It can be used to compare against earnings of another stock, sector or the whole market and even bond yields.
- A relative valuation to use it with reference.
- Look for EY >= 10%
- Piotroski Score
- It is a quality score that leads to an easier valuation.
- The first four criteria of the Piotroski Score count towards profitability.
- Points 5-7 of the Piotroski Score, looks
at the health of the balance sheet in terms of debt and the number of
shares outstanding.
- The last two factors of the Piotroski Score looks at operating efficiency.
- Positive net income compared to last year
- Positive operating cash flow in the current year
- Higher return on assets (ROA) in the current period compared to the ROA in the previous year
- Cash flow from operations greater than Net Income
- Lower ratio of long term debt to in the current period compared value in the previous year
- Higher current ratio this year compared to the previous year
- No new shares were issued in the last year
- A higher gross margin compared to the previous year
- A higher asset turnover ratio compared to the previous year
- How to use?
- Look for trends. Increasing? or Decreasing?
- Price to Intrinsic Value
- This one is tricky. How to get intrinsic value?
- Intrinsic value can be caculated via DCF, Graham Net Net, Graham Growth Value, Katsenelson's Absolute P/E, EV/EBIT, etc...
- The idea behind using a price to intrinsic value ratio is to invest in the most undervalued stock. If you have 10 stocks - how do you know which one to buy? Go for the one with lowest ratio
- DuPont model for ROE
- 3 step formula or 5 step formula
- ROE is a way to measure the effectiveness of management. Now you can see in which area management is exceeding or lacking.
- To find which element to blame if ROE not perform well.
References:-
- Return of Equity (ROE) reveal how much the company is making compared with how much it
has invested to make that.
- It is one of the most important indicators of a
firm’s profitability and potential growth
- Companies that boast a high ROE with
little or no debt are able
- to grow without large capital expenditures
- allowing
the owners of the business to withdrawal cash and reinvest it elsewhere
- DuPont equation
- ROE = Net Income/Equity
- = Net Income/Sales * Sales/Total Assets * Total Assets / Equity -
The sales and total asset on the right side of the equation negate each other, seeing as one is in
the numerator and one is in the denominator
- = Net Income Margin * Asset Turn Over * Financial Leverage
- It tells
where a company's strength lies and where there is room for improvement
- A firm can achieve higher ROE if
- Higher Net Income Margin & asset turn over
- Increase Financial Leverage - when times are good, leverage amplifies
ROE, but in bad times, it can hurt ROE badly. And, too much leverage can
make a company becoming risky in time of economic downturn and financial
crisis.
- It is important to look at the long-term trend
in ROE to make sure that it is not steadily declining significantly.
- One must be
aware about the economic cycles and that when a company grows bigger, it is harder
to continue improving its ROE which is already high.
References:-
- The most important goal for a company is to make money and keep it
- it determine a company's ability to pay investors a dividend, profitability is reflected in share price.
- Profit Margin - to gain insight into how efficiently a company uses its resources and how much income it generates
from operations.
- How much a company squeezes from it total revenue or total sales? (not measure how much earn from assets. equity or invested capital)
- Margins - earning expressed as a ratio, or percentage
- 3 key profit margin ratios:- gross profit margins, operating profit margins, net profit margin.
- Gross Profit Margin
- Gross Profit Maring = (Revnue - Cost of Goods Sold)/Revenue
- how efficiently management uses labor and supplies in production process.
- Companies with high gross margins will have a lot of money left over to spend
on other business operations, such as research and development or marketing
- When labor and material costs
increase rapidly, they are likely to lower gross profit margins - unless, of
course, the company can pass these costs onto customers in the form of higher
prices.
- It can vary drastically from
business to business and from industry to industry
- Operating Profit Margin
- Operating Profit Margin = EBIT/Revenue
- how successful a company's management
has been at generating income from the operation of the business
- how much cash the business throws off - a more reliable measure of profitability since it is harder to
manipulate with accounting tricks than net earnings.
- Net Profit Margin
- Net Profit Margin = Net Profit after Tax/Revenue
- To be comparable from company to company/year to year, net profit after tax must be shown before minority interests have been deducted and equity income added. Investment Income - can change dramatically from year to year.
- High Profit Margin - it also has one
or more advantages over its competition.
- It have a bigger cushion to protect themselves during the hard time and not easy to get wiped out in a downturn.
- It able capture more
market share during the hard times - leaving them even better positioned when
things improve again.
- Margin ratios never offer perfect information - it depend on the timeliness and accuracy of the financial data that
gets fed into them, and analyzing them also depends on a consideration of the
company's industry and its position in the business cycle. -It highlight companies that are worth further examination.
References:-
