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Jelly Roll Capital Equity Research |
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Market Analysis, Education, and Wall Street-Quality Stock Reports |
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Examining Return on Equity (ROE): Part I |
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Return on Equity (ROE) is a common financial ratio used by investors to assess how effectively a company employs capital invested in it by shareholders. First, a few formulas:
Return on Equity = Net Income/Stockholder’s Equity Note: Other measures such as EBIT can be used instead of NI.
Financial Leverage Multiplier: Total Assets/Total Equity
One trait of ROE is that the percentage return equals the maximum amount a company can grow without taking on additional financial leverage (i.e. debt). While debt is not necessarily bad, the ability to achieve high organic growth without increasing leverage is always a plus. Because ROE does not take debt into account, it is also important to look at Return on Assets (ROA) as well. While ROE is not the end-all metric of financial analysis, it can be used to make several interesting observations about a company. To start with, we will look at consumer healthcare company Johnson & Johnson (JNJ Stock Brief here). It is most useful to look at ROE over a period of several years to see if management has continued to efficiently return money on shareholder capital. Over the last 10 years, Johnson & Johnson’s ROE has essentially held in a band between 26% and 30%. This is a very high return, and indicates what many of you probably know - Johnson & Johnson is a very well-run and profitable company. While a ROE near 30% is very good (only about 1/3 of companies with a market capitalization above $50 billion have an ROE over 25%), what makes Johnson & Johnson’s current ROE more noteworthy is that the company has become significantly deleveraged over that time period as well (a 50% reduction to 1.5), meaning management has been not only reducing long-term debt relative to equity (such debt doubled in the last decade, whereas equity quadrupled), but has continued to earn the same high return on new investments as it has in the past. Compare the results achieved by Johnson & Johnson to those of another well-known large-cap name, Boeing (ticker: BA). Boeing’s ROE is approximately equal to that of Johnson & Johnson, at around 28% right now. How has this been accomplished? Boeing has more than doubled its financial leverage, from about 2.4 in 1996 to 5.9 today. A comparison between then-and-now balance sheets shows that equity is essentially flat over the last decade, whereas debt has grown from $16 billion to over $50 billion. Obviously, these ROE numbers are not equal - Boeing must “juice” their ROE by loading the company with debt, whereas Johnson & Johnson can naturally have a large return on equity without additional financing. Looking at ROA would make this more clear because it is not dependent on financing structures as ROE is, but that is an issue for another day. For now, realize that ROE is a useful measure, but only if the parts are properly understood and compared over time. Additionally, the example here is one reason why I believe JNJ is a good stock, but BA is overpriced. Disclosure: The writer has no position in BA or JNJ.
For more on Johnson & Johnson, read our JNJ Stock Brief. |