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Course 206
Levers of ROE

Introduction

Return on equity, or ROE, is the most common measure of a company's profitability. But ROE is itself the product of three ratios, or levers: net margin (earnings/revenues, expressed as a percentage), asset turnover (revenues/assets), and financial leverage (assets/equity). Multiplying the three levers together gives us ROE, and raising any one of the three levers will increase ROE. (Note that revenues and assets cancel out, leaving us with the more familiar formula for ROE, earnings/equity.)

Net Margin and Asset Turnover

Not all these levers are made equal. The first two levers, net margin and asset turnover, are measures of how efficient a company's operations are. It's pretty intuitive that increasing net margins--which means a company is turning a larger portion of its sales into profits--will increase profitability. A high asset turnover, which expresses how many times a company sells, or turns over, its assets in a year is also a sign of efficiency. The product of net margin and asset turnover is called return on assets, or ROA, and it is an excellent measure of operational profitability. The higher a company's ROA, the better. Some companies emphasize high net margins to pump up their ROA; others emphasize rapid turnover. For example, compare Coca-Cola KO against Cott COTTF, a Canadian producer of discount, non-brand-name soda. Between 1994 and 1998, Coke's net margins averaged 18%, while Cott's average net margin was less than 5%. Coke was able to leverage its strong brand name into higher prices, resulting in fat net margins. Cott, on the other hand, targeted the low end of the market with bargain prices, earning a slimmer profit margin on each sale but (hopefully) moving a lot more merchandise per unit of assets. Indeed, Cott's asset turnover during the same period was 1.7, compared with Coke's 1.1. But that wasn't nearly enough to offset Coke's much higher net margins, and Coke's ROA of 24% trounced Cott's 4%. This isn't to say that focusing on asset turnover at the expense of margins is always a bad thing. Wal-Mart WMT has lower margins than most other major retailers because it emphasizes lower prices. But Wal-Mart also generates a higher ROA than most of these competitors because it operates so efficiently that its asset turnover is much higher. In 1998, for example, Wal-Mart's asset turnover was 2.8, as opposed to 1.1 for old-line retailer Sears S and 2.0 for rival discounter Dayton-Hudson DH.

Financial Leverage

The third lever of ROE, financial leverage, is a measure of how much debt the company carries. The way in which raising financial leverage increases ROE is a little less intuitive. One way to think about it is that if a company adds debt, its assets increase (because of the cash inflows from the debt issuance) and so does its total debt. Since equity is equal to assets minus total debt, a company can decrease its equity as a percentage of its assets by increasing its debt. In other words, assets--the numerator of the financial-leverage figure--increases, so the overall financial-leverage number rises, boosting ROE.

The Risks of Debt-Driven Returns on Equity

But does it matter if a company's high ROE comes from high debt and not operating efficiency? If a company has a steady or steadily growing business, it might not matter that much. For example, companies in the consumer-staples sector, where demand is stable, can handle fairly large debt loads with little problem. And the judicious use of debt by such companies can be a boon to shareholders, boosting profitability without unduly increasing risk. If a company's business is cyclical or volatile in some other way, though, watch out. The problem is that debt comes with fixed costs in the form of interest payments. The company has to make those interest payments every year, whether business is good or bad. When a company increases debt, it increases its fixed costs as a percentage of total costs. In years when business is good, a company with high fixed costs as a percentage of total costs can make for great profitability because once those costs are covered, any additional sales the company makes fall straight to the bottom line. When business is bad, however, the fixed costs of debt push earnings even lower. That is why debt is sometimes referred to as leverage: It levers earnings, making strong earnings stronger and weak earnings weaker. When companies in cyclical or volatile businesses have a lot of leverage, their earnings therefore become even more volatile. So the next time you're thinking about profitability, make the distinction between the kind that is internally generated and the kind that is inflated by debt. You can make a lot of money on stocks of companies structured like the latter, but your return is more assured with stocks of companies like the former.

Quiz 206
There is only one correct answer to each question.

1 Which of the following is <em>not</em> one of the three levers of ROE?
a. Earnings/revenues.
b. Assets/equity.
c. Assets/revenues.
2 High asset turnover:
a. Is a sign of efficiency.
b. Is a sign of inefficiency.
c. Always means a low net margin.
3 If a company has lower prices than its competitors:
a. It will always have a lower return on assets.
b. It can have a higher return on assets if its asset turnover is higher.
c. It will always have a higher return on assets.
4 Which of the following does <em>not</em> happen when a company takes on debt?
a. Its assets increase.
b. Its equity increases.
c. Its return on equity increases.
5 For companies in cyclical or volatile industries, high financial leverage:
a. Is more desirable than for companies in stable industries.
b. Decreases their fixed costs as a percentage of total costs.
c. Makes their earnings even more volatile.
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