Return on Equity
The way analysts usually measure return on capital for publicly traded companies is return on equity, or ROE. This is calculated by dividing net earnings by shareholders' equity. Shareholders' equity, or equity capital, is equal to total assets minus total liabilities. That is the part of the company owned by stockholders--the capital they have invested in the company.Dell Computer DELL earned an incredible 63% on its equity capital in 1999. In other words, for every $1 of shareholder money invested in the firm, Dell generated an annual profit of $0.63. Be careful, though. It's easier to post a large ROE in a single year than it is to maintain that large ROE over a longer period. Oil driller EOG Resources EOG, for example, earned 58% on its equity in 1999, but if you average the company's ROEs over the five-year period from 1995 to 1999, the figure drops to a much less impressive 19%. It's that long-term return on capital that we're interested in.
Let's go back to the restaurant example. Instead of just one sci-fi restaurant, let's say you want to open a whole chain of them. In the early years of building your empire, you'll be adding to your capital base aggressively. But because of the costs of opening restaurants, you will probably take losses; most companies in their formative stages lose money. If after a few years you've sunk $500,000 into your restaurants but are losing $50,000 annually, your return on capital is negative 10%. (A pretty realistic figure for the sci-fi idea, I'd say.) It's not necessarily bad for a company to earn a negative return on equity--if it can earn a high return in the future, that is. An investor will stomach a negative 10% ROE for your sci-fi restaurants if he believes they can earn much higher returns in the future.
The trouble is, in a company's rapid-growth phase, when returns on equity are most often small or negative, it's tough to separate a good business (one that can earn a high ROE) from a bad business (one not able to). After all, each is losing money. Analyzing such companies means asking questions like "Is this a company with enough pricing power to eventually command a premium price for its product?" And "Is this a company with enough of a cost advantage that it can undercut the competition?" It means, in other words, asking whether the company's business can either generate a high net margin (profit/sales) or a high asset turnover (sales/assets), the two key components of a high return on capital.
posted by MobyGrape @ 2:35 PM
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