Woe be to those who missed out ROE

I was just waiting for the bus to come when I thought more in depth about the concept of return on equities, otherwise known as ROE for short. It’s not those little things that you put onto sushi though.



WARNING: THIS IS ONE OF THE MOST CHEAM AND LONGEST POST I EVER DID ON ACCOUNTINGS. PROCEED WITH CAUTION.

ROE, usually denoted as a percentage, is defined as the net profits per equities of a company. Equity is the amount that is left when you subtract total liabilities from total assets. In this article, I’ll explore the idea of how difficulty it is to maintain a consistent ROE throughout the years. I figured out an example while waiting for the bus, so I’ll just use that one to illustrate.

Suppose Bullythebear Company (BTB for short) is opening for business. To start off the business, BTB managed to raise $150 from venture capitalist. However, because BTB still needs to buy some fixed asset to kick start the business, it’ll have to borrow $50 from the Kingpin. Being a kind soul, Kingpin do not require any interest to be paid up, so there is no interest charged on the $50. BTB will immediately have a cash/cash equivalent of $200, listed as a component under the assets column. The balance sheet will look somewhat like this:




BTB proceed to buy a piece of machinery (that can be used forever and hence do not need depreciation charges at all) that is used to produce the revenue, costing a princely sum of $120 paid up front without credit. Hence, from the cash/cash equivalent of $200, $120 of which will be used up, leaving $80 (200 – 120 = 80) left. The balance sheet looks like this:




So after the first year of business, BTB made a revenue of $100, and after all the costs and taxes involved, retains a net profit of $52. The $52 will be received immediately and will add to the initial $80 cash, hence the cash/cash equivalent will be raised from $80 to $132 (80+52 = 132). There is a corresponding entry in equity under retained earnings, which is the exact amount as the cash/cash equivalent, being $52. The balance sheet and income statement looks like this:




Let’s do some FA for the company at this present moment.

ROE is 25.74% (52/(150+52) = 25.74%).
Net margins is 52.0% (52/100 = 52%)
Financial leverage is 1.25 ((132+120)/202)
Asset turnover is 0.40 (100/(132+120))

Hey, not bad numbers at all!

Into the second year, BTB manages to raise revenue by 15%, which is pretty decent. Unfortunately, the direct and indirect costs associated with making the revenue also increases proportionately, creating a net profit of $59.80. Again, this sum is collected in full without credit and thus increases both the cash/cash equivalent and the retained earnings. The balance sheet and income statement looks like this:



Take a look at the figures now
Revenue increment: 15%
ROE is 22.84%
Net margins is 52%
Financial leverage is 1.19
Asset turnover is 0.37

Hey, the ROE drop from 25.74% in the first year to 22.84% in the second year, even though the company is pretty decent. The net margin remains the same and the revenue increase by 15%. This is the difficulties that company faces when they want to maintain their ROE – it’s not easy, especially when they hold their retained earnings in cash which is sitting there earning a miserable interest. The more the company earns, the harder it will have to work in order to maintain the same ROE because the asset base increases!

Let’s see what happens in year 3 when there is a great year for our BTB company, with revenue increasing by 29.6%. Here’s the balance sheet and income statement:



Here are the figures:
Revenue increment: 29.6%
ROE is 22.84%
Net margins is 52%
Financial leverage is 1.15
Asset turnover is 0.38

Here, the ROE is maintained at 22.84%, same as the previous year. But look what it takes to achieve this same consistent ROE feat – a revenue increment of nearly 30%. Can you see how hard it is to keep on maintaining the same ROE again and again, year after year? It takes not only good use of the retained earnings, but also great management insight to invest the excess earned every year to good use. It’s not easy at all!

Here's a few insights that I gained by doing this rather rigorous way of exploring how ROE numbers are generated:

1. ROE is very difficult to maintain. Every year, the management will have to decide on how to maintain ROE, which isn't fun at all. Holding too much cash is great, but it'll drag down the ROE. Invest more into their business - what if they can't generate the kind of returns? Management will also have to think about giving back earnings in terms of dividends, especially when they are not confident of using it wisely. The worst they can do is to invest in non-core business for the sake of expanding their empire. It'll drag down ROE, suck up precious cash, and even have to spend money to get out of it eventually.

2. This comes as a surprise actually. I knew it but never really thought hard about it. Financial leverage drops as one gets more and more asset base. This is the result of increasing the asset faster than one's borrowings. Just by retaining cash, the financial leverage ratio drops substantially.

3. I've a much better understanding of the relationships between the 3 statements found in financial reports. I used to do all these accounting in the past (I blogged it an article found here), as part of my journey to learn fundamental analysis, and I remembered I took half a day to do just a simple tracking. This one, I did it in 1 hour. Hey, practise do make prefect - just keep staring and crunching numbers for 1 full year, it'll work wonders.

4. I start to appreciate more when I see companies with high and consistent ROE. Take a look at Hongguo:

----------ROE(%)
2003------19.68
2004------20.49
2005------22.46
2006------22.31
2007------22.30
2008------19.7 (*)

* estimation based on 9M08's ROE