Return On Stock Investment
Return on stock investment is the amount a business earns on both the capital owned by its shareholders and the capital supplied by lenders on a long-term (over one year) basis. A business may borrow capital rather than issue equity if it needs capital and believes it will generate greater returns on the capital than the costs of borrowing it.
Suppose a business with $100 million in shareholder equity borrows $50 million from long-term lenders and then generates earnings of $15 million on that total capital. Its return on stock investment will be 10% (15/150). But this leveraging boosts the business's return on equity—earnings of $15 million on shareholder equity of $100 million means a return on equity of 15%.
Using debt to boost return on equity is common but by no means imperative. Some companies generate sufficient cash from their operations to enable high returns on equity more cheaply than they could by borrowing. As was noted earlier, Microsoft is debt-free, generating returns on equity of nearly 34% and returns on stock investment that are just about the same (a similar near 1:1 ratio holds across the computer industry).
The norm among the S&P 500 is to use debt, driving the average return on equity to about 22% while return on stock investment is about 14%. GE exploits leverage with more spectacular results, with returns on equity of nearly 27% tripling return on stock investment of just above 9% (similar results hold across the conglomerate sector).
Return on Assets
Return on assets is the amount a business earns on all its resources—not only shareholder equity and long-term borrowing but short-term resources generated by effective management of working capital. A business may seek short-term, low-rate loans or buy goods on credit that it resells for cash, thus increasing the assets available for deployment at low or no cost. Those assets contribute to incremental increases in earnings, boosting both return on equity and return on assets.
Suppose a business maintains an average amount of short-term assets of $20 million over a year (by continually repaying the obligations as they come due and incurring new ones as rollovers). That could increase incremental annual earnings by, say, $2 million. Thus, a company with shareholder equity of $100 million and long-term debt of $50 million, carrying that additional $20 million in the short term and earning $17 million, generates a return on assets of 10% (17/170). This deployment boosts return on stock investment to 11.3% (17/150) and return on equity to 17% (17/100).
Return on assets is thus the toughest measure of performance based on returns, as it reveals the results of deploying all the assets at management's disposal. Starting with a high return on assets should yield a high return on stock investment and hence on equity. (Some analysts calculate a "financial leverage index" equal to the return on equity divided by the return on assets.)
Higher returns on assets are achieved by squeezing earnings out of fewer or smaller asset bases. Microsoft starts off with a return on assets of 25%, suggesting a relatively low level of asset intensity, freeing it from dependency on debt and enabling it to generate returns on equity of nearly 10 points more. At the other extreme, GE starts off with a return on assets of just 3%, meaning it must manage its capital structure to use debt skillfully and deploy assets efficiently in order to get the higher returns on equity of about 27% that it achieves.
Microsoft is asset-nonintensive, whereas GE is quite asset- intensive. The earnings of many companies (Amazon.com maybe) are driven by brand names and/or inventory and distribution systems far more than by the plants and other physical resources that make up their balance sheet assets. Microsoft relies more on fixed and other assets but also is able to extract prodigious earnings from its brand name and market position. GE's asset-intensive business requires heavy stock investment in plants and equipment even as its products enjoy enormous brand recognition ("We bring good things to life").
It is too soon to tell how Amazon.com will fare in the contest for high returns on assets. Certainly its business model is designed to minimize asset intensity. Its brand name and Internet presence are the key drivers of sales and hence earnings. It minimizes its fixed asset needs by avoiding the bricks-and-mortar store operations to which Barnes & Noble and other traditional retailers devote resources.
Amazon.com's just-in-time inventory management is designed to reduce the carrying costs of inventory. Its trade terms with customers and suppliers drive incremental earnings by superior short-term working capital management—it receives revenues from customers as products are ordered but usually need not pay its suppliers for those goods until some 30 to 60 days later. Internet customers base purchases on pictures and images on the Internet screen, moreover, meaning Amazon.com does not suffer from books damaged by customers thumbing through them. Bricks-and-mortar bookstores incur losses from such damaged books (though they have the right to return damaged books to publishers, the result is often a lower discount on purchases from them). These characteristics of low asset intensity are extremely favorable to Amazon.com, though it remains a hard business to assess given its relative youth and negative earnings.
THE FULL TOOL CHEST
This tool chest of ideas helps you assess a company's liquidity, efficiency and performance. The tools can be adapted from the basic metrics outlined here to deal with special situations and more advanced analysis.
A few examples of measures that help further gauge various aspects of a company's relative and probable future success are as follows. Quality of income (cash flows provided by operating activities divided by operating income) tells you what portion of income is actually turning into cash to gauge the liquidity position. The amount of annual depreciation expense can be a good proxy for future capital stock investment needs. Sales per employee helps evaluate overall productivity.
A company's key ratios vary with time, and any trends are important guides to managerial efficiency and performance. Therefore, you might look at all the expenses on the income statement over several years. There is no reason to automatically assume that any particular ratio or trends will continue, but history does help define probabilities for the future.
Suppose, for example, you see a large reduction in an expense for research and development. That would significantly increase income in a period. But growth in income resulting from the reduction in such an expense would not mean that the business is being managed more efficiently. It could even mean that there are reasons to worry about its prospects for growth in the future.
Or take receivables turns. Suppose the average number of collection days during a period increases materially in relation to the credit terms. Maybe part of any sales growth during the period is due to a relaxation in credit collection policies rather than to business efficiency. If those accounts are more likely to go uncollected, the sales growth might look good today but there'll be hell to pay tomorrow.
We could go on and on but don't need to. 3 Get acquainted with the key ratios mentioned above and you'll instantly be miles ahead of the crowd in your ability to distinguish strengths and weaknesses in numerous businesses within your circle of competence. Focus on the strong ones and keep looking—they might have the value you want, especially if they pass the tests in the next chapter.
