||Calculate Management Effectiveness Ratios
Management effectiveness ratios tell you
whether company management uses shareholders' equity and company
assets to produce an acceptable rate of return
Even with the best products
or services, companies have
trouble delivering strong long-term growth unless their management
makes sure that everything operates effectively and efficiently.
Management effectiveness ratios compare financial measures from
company financial statements to evaluate management performance. Of
all the fundamental criteria that long-term investors consider, one
of the most important is return on
equity (ROE), which is a basic test of how well a
company's management uses its money—are they
increasing the overall value of the business at an acceptable rate?
Return on assets (ROA) takes
another view of
management's effectiveness by illustrating how much
profit the company earns for every dollar of its assets, such as
money in the bank, accounts receivable, property, equipment,
inventory, and furniture. One reason to consider ROA as well as ROE
is that the latter can make high-debt companies look more effective
than low-debt firms with the same earnings and assets.
Evaluating Return on Equity
Calculate ROE with the formula in .
Example 1. Formula for ROE
% Return on Equity = (Annual Net Income / Average Shareholders' Equity) * 100
The concept of equity is
hard to grasp, so here's a brief lesson. Simply
defined, shareholders' equity is the difference
between the total assets and total liabilities of a company.
It's an accounting convention that represents the
assets that a business has generated in its lifetime from two
Fundamental analysts consider company assets that
don't have corresponding liabilities to be equity
generated by the skill of company management. The higher and more
consistent the returns that management generates on money invested in
the company, the better off shareholders will be.
You can find net income, also known as net earnings, on a
company's income statement, which is a financial
statement required in an annual 10-K SEC filing.
Shareholders' equity appears at the bottom of a
company's balance sheet, which is also in the 10-K
shows a simplified example of Home
Depot's 2003 financial statements, created with data
obtained from the Home Depot web site
(http://www.homedepot.com). First, identify net
income near the bottom of the income statement (listed as Net
Earnings in this case).
Table 0. Home Depot financial statements
Income statement (in millions)
Balance sheet (in millions)
NET SALES 58,247
Cost of Merchandise Sold 40,139
GROSS PROFIT 18,108
Total Operating Expenses 12,278
OPERATING INCOME 5,830
Interest Income (Expense):
Interest and Investment Income 79
Interest Expense (37)
Interest, net 42
EARNINGS BEFORE PROVISION FOR INCOME TAXES 5,872
Provision for Income Taxes 2,208
NET EARNINGS 3,664
Total Current Assets 11,917
Property and Equipment, at cost 20,733
Less Accumulated Depreciation & Amortization 3,565
Net Property and Equipment 17,168
Notes Receivable 107
Other Assets 244
TOTAL ASSETS 30,011
LIABILITIES AND STOCKHOLDERS' EQUITY
Total Current Liabilities 8,035
Long-Term Debt, excluding current installments 1,321
Other Long-Term Liabilities 491
Deferred Income Taxes 362
Common Stock, par value $0.05; authorized:
10,000 shares, issued and outstanding 2,362
Shares at 2/ 2, 2003 118
Paid-in Capital 5,858
Retained Earnings 15,971
Accumulated Other Comprehensive Loss (82)
Unearned Compensation (63)
Treasury Stock, at cost, 69 shares
at 2/ 2, 2003 (2,000)
Total Stockholders' Equity 19,802
Then, look at the balance sheet and find
shareholders' equity at the very bottom. Home Depot
calls it Total Stockholders'
Using the formula in , you can calculate
Home Depot's ROE.
Example 2. Calculating Home Depot's ROE
Home Depot's ROE = $3,664 / $19,802
= 0.185 or 18.5 percent
Home Depot's ROE is 18.5 percent, and you might be
thinking "So what?" Think about the
value of your home, your portfolio, or your business. If you were to
increase its value by 18.5 percent in a year, you would be doing
quite well. That's a much better return than you
would receive from a bank savings account, for instance.
Some professional investors invest only in companies with a ROE
higher than 15 percent. This guideline assures that company
management has so far been effective in building up the value of
their company. Home Depot exceeds this by a comfortable margin.
As with many other financial ratios, you can learn more about a
company by comparing its ROE to its historical trends, as well as to
other companies in the same industry. First, take a look at how Home
Depot's recent results compare to its past.
In a spreadsheet, it's easy enough to calculate ROE
for the past five years, as shown in .
EdgarScan (http://edgarscan.pwcglobal.com) is a good
source of historical SEC filings already formatted in Excel
spreadsheets. Simply isolate net income and
shareholders' equity from each annual 10-K filing
and add the ROE calculations, as shown in Examples and .
Example 3. Excel function for ROE
Annual ROE (cell B4) = B2/B3
Figure 1. Calculate ROE for several years to look for trends
Example 4. Excel function for the five-year average ROE
5-year Average ROE (cell G4) = AVERAGE(B4:F4)
In , the formula in cell B4 was copied to
cells C4 through F4. The cells are formatted as a percentage to one
With these calculations, you can evaluate Home
Depot's past performance in detail. The
company's ROE has been fairly stable over the past
five years. The company recovered from a downward trend in 2001 and
2002, which is a good sign. It's not unusual to see
some fluctuation in ROE from year to year, but well-managed companies
produce fairly stable results over the long term. Steadily rising
ROEs are desirable, but that can't go on forever.
Eventually a company's ROE will stabilize or start
to fall slightly, which might not be negative if a company is
maturing or receding from extraordinary performance levels.
Calculating a company's long-term average ROE can
help smooth out short-term fluctuations and help you evaluate the
stability of the ROE. Home Depot's most recent
results exceeded its five-year average, which is what you want to
see. If ROE declines for three or more consecutive years, you should
research the company to understand the reasons for the fall. For
example, cyclical companies by their nature see lower earnings as
they reach the bottom of their cycle, so their ROEs trend up and down
with the economic cycle.
ROE is another measure that you should compare within a
company's peer group. The MSN Money web site
(http://money.msn.com) calculates return on
equity for you, and shows average ROE for the
company's industry and the overall market. Enter the
ticker symbol of the stock that you're studying and
click Go. On the stock page, click Financial Results, then Key Ratios
in the navigation bar, and then click the Investment Returns link, as
shown in .
Figure 2. MSN Money offers ROE data and industry comparisons
In , you'll notice a
ten-year chart of a company's ROE where
it's easy to see that the company's
management has been doing its job well. In the table below the graph,
you can also see that MSN Money calculates Home
Depot's 2003 ROE as 18.4 percent. Small differences
between this figure and the number calculated from SEC filings is
likely due to rounding. Home Depot's ROE is somewhat
below the industry average of 19.3 percent, but it's
well above the S&P 500 average of 9.6 percent and the ROE
guideline of 15 percent.
The Return On Equity (5-Year Avg.) a few lines down in the table is
more telling. Here, Home Depot's performance is even
better with an average ROE of 17.9 percent compared to the
industry's 17.0 percent, and 12.1 percent for the
Five-Year Industry Averages for Return on Equity and Return on Assets (1998-2002)
Evaluating Return on Assets
Because ROE only compares net income to
shareholders' equity, a company that has raised
working capital from bonds and borrowing might show a higher return
on equity than a competitor without being any more effective at
putting the shareholders' equity to work growing the
company. Return on assets can help you understand how well a company
uses debt as well as shareholders' equity.
You'll find a company's total
assets on its balance sheet and can calculate ROA, as shown in .
Example 5. Formula for ROA
% Return on Assets = (Annual Net Income / Total Assets) * 100
Using the data from Home Depot's financial
statements in , you can calculate its
ROA, as shown in .
Example 6. Calculating Home Depot's ROA
Home Depot's ROA = $3,664 / $30,011
= 0.122 or 12.2 percent
Professional investors won't often consider stocks
with ROA lower than 5 to 8 percent, so Home Depot's
management has exceeded that standard. As with ROE, you should
evaluate trends in ROA, and compare a company's ROA
to its competitors and the market in general. A stable ROA over the
years indicates that management is effectively managing its total
resources to generate profits for the company. Looking at Home
Depot's history in a spreadsheet (see ), you can see that the
company's ROA has been consistent over the past few
Figure 3. Examine ROA over a period of five years to check the company's trend and average
ROA varies significantly by industry, as shown in the sidebar on
industry average ROE and ROA. An automobile manufacturer requires a
huge amount of assets—factories, materials, and parts—to
build those SUVs that are so popular. Software companies, on the
other hand, don't need big manufacturing plants to
turn out their products—after they develop a program, they just
stamp out software CD-ROMs, package them, and ship them to customers.
They might even outsource those tasks to reduce the employees and
buildings they need.
To compare Home Depot's 12.3 percent average ROA to
the industry, refer to MSN Money. shows
that the company's ROA is better than the industry
average of 10.5 percent and worlds better than the
2.0 percent average of the S&P 500.
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