Jelly Roll Capital Equity Research

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More on Leverage: Is that ROE Natural?

Last week I discussed Return on Equity (ROE) and how financial leverage (that is, a company funding its assets through debt rather than equity) can increase ROE, meaning that some ROEs are essentially better than others. While I don’t categorically dislike leverage, I would say that I prefer a company to have low debt levels relative to equity. In the previous column, I highlighted the difference between the high ROEs achieved by Boeing (ticker: BA) and Johnson & Johnson (JNJ Stock Brief). Continuing on with the theme of separating ROE by the “natural” or “leveraged” varieties, and over the next two days I am going to present more companies from each category. Remember that leverage is a double-edged sword, and can greatly help in good times - but the downside is also proportionally worse. Companies that rely on leverage have less room for error, so make sure you have an extra high degree of confidence in a company’s management and business model before investing in highly levered company.

In Love with Leverage:

Continental Airlines (CAL) is finally profitable - but don’t let that triple digit ROE fool you: CAL achieves such a feat with a financial leverage multiplier of almost 50.
Many brokerages have been hit hard over the last several weeks with selling. E*Trade (ETFC) is one example of a debt-heavy company; it uses financial leverage of over 13x to achieve an 18% ROE.
Private equity target TXU Corp. (TXU Stock Brief) carries a large debt load, which gives it leverage over 12x in its most recent reporting period.
One company I like as an investment that uses a large financial leverage multiplier is U.S. Tobacco (UST), which achieves a huge 700% ROE partly through a 21x multiplier. Note, however, that Return on Assets (ROA) is an already high 35%, which is partially the reason I like UST so much.
The well-publicized woes of sub-prime lenders has brought many companies in the industry to bankruptcy, but mortgage giant Countrywide Financial (CFC) only derives about 10% of business from that segment. Its financial leverage multiplier of 14x helps it achieve a ROE of over 19%.