# Altria's Return On Equity Is Increasing For The Wrong Reasons

## Summary

The company's ROE is increasing because of decreasing accumulated other comprehensive income.

The stock offers value to investors at around \$54.

I've been happy with my swap out of T.Rowe Price for Altria back in late November.

Most investors take a look at return on equity as a measure of how well a company is doing with respect to net income as a ratio to shareholders equity on the balance sheet. Companies such as IBM, Boeing, or Altria even have huge returns on equity. Typically a high return on equity value is pretty nice to have, but not all returns on equity are equal.

Although it is a straight ratio as suggested, it is a bit more complex than that. Not many investors know this, but return on equity can actually be decomposed into three parts, made popular by DuPont back in the 1920s. The decomposition of return on equity tells us three things:

1. Operating efficiency, which is measured by profit margin
2. Asset use efficiency, which is measured by total asset turnover
3. Financial leverage, which is measured by the equity multiplier

Prepare yourself for some algebra; I promise it will be pretty easy. We already know that profit margins are dictated by the equation of profit/sales. Total asset turnover is dictated by the equation of sales/assets and the equity multiplier is dictated by the equation of assets/equity. So when we multiply them all together we get the following proof:

 Profit * Sales * Assets = Profit = ROE Sales Assets Equity Equity
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I for one am looking at return on equity in a much different manner now after learning this method. The part of the proof above that got me to investigate ROE more intently is the equity multiplier portion. Depending on how a company chooses to finance its assets (by debt or by equity), the equity multiplier can be really huge, causing the overall return on equity to be high. Personally I don't like a whole lot of debt on the balance sheet. But for capital structuring reasons debt can be used as a tax shield as taxes are calculated after interest payments.

Today I've chosen to evaluate Altria's (NYSE:MO) ROE because it is one stock I have in my portfolio and I've noticed that its ROE has increased (see table below) from the previous quarter and would like to see why.

 Quarter 2015-06 2015-09 ROE 161.1% 185.9%
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Operating Efficiency

As mentioned earlier, operating efficiency is the profit divided by the sales. This in essence tells us how efficiently the company is operating from an operations, financial, and tax perspective. From the table below we see that the profit margin increased by 1.3% for the company from the prior quarter. We see that net income has gained 2.5% and sales increased by 1.2% over the period. Nonetheless, profit margins increased thanks to a bigger gain in net income which means the increase in ROE was partially due to the profit margin.

 2015-06 2015-09 % Change Q/Q Net Income ttm \$5,082 \$5,210 2.5% Sales ttm \$18,513 \$18,738 1.2% Profit Margin 27.5% 27.8% 1.3%
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Total Asset Turnover

From the equation I showed above, the total asset turnover ratio is defined by sales divided by assets. Total asset turnover gives us the big picture of how well the company is transforming all of its assets into sales. From the table below we see that the total asset turnover actually increased from the prior quarter. Total sales increased while average assets decreased. This portion of the equation tells us that the ROE move was related to the company's ability to make more money on their assets when compared to what they've done in the past.

 2015-06 2015-09 % Change Q/Q Sales ttm \$18,513 \$18,738 1.2% Average Assets ttm \$33,660 \$33,139 -1.5% Total Asset Turnover 0.55 0.57 2.8%
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Equity Multiplier

The equity multiplier is the part of the ROE equation that I don't like. It's with this portion of the equation that a company can choose to get risky or play it safe. It completely depends on how the company manages its debt, equity, and on how well the cash flows are coming in to pay those debts. From the previous portions of the equation we pretty much determined that the ROE has increased thanks to the increase in profit margins and asset turnover but we still have to look at the equity multiplier.

An equity multiplier number of 11.8 is very high for my taste. But it isn't until we break it out like I did in the tables below that we can see if it is a good thing or a bad thing. As we can see assets have decreased and equity has decreased but at a higher rate, ultimately having a positive impact on the ROE.

 2015-06 2015-09 % Change Q/Q Assets (avg ttm) \$33,660 \$33,139 -1.5% Equity (avg ttm) \$3,155 \$2,803 -11.1% Equity Multiplier 10.7 11.8 10.8%
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If we dig a little further we see that the equity value decreased (32.8%) over the past year primarily because of the decrease in accumulated other comprehensive income. AOCI is usually associated with the unrealized gains and losses from investments which the company has not settled yet. These types of transactions usually include foreign currency transactions or pension funds.

 Stockholders' equity 2014-09 2014-12 2015-03 2015-06 2015-09 Common stock \$935 \$935 \$935 \$935 \$935 Additional paid-in capital \$5,723 \$5,735 \$5,754 \$5,768 \$5,800 Retained earnings \$26,066 \$26,277 \$26,271 \$26,698 \$27,118 Treasury stock -\$26,976 -\$27,251 -\$27,482 -\$27,744 -\$27,809 Accumulated other comprehensive income -\$1,454 -\$2,682 -\$2,945 -\$2,878 -\$3,157 Total stockholders' equity \$4,294 \$3,014 \$2,533 \$2,779 \$2,887
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Conclusion

Altria's return on equity is increasing from the prior quarter and it is primarily increasing because of the increase in the equity multiplier. When you multiply all the numbers together you get an ROE of 186%, a move up of 15.4% from the previous quarter. This ROE makes Altria the highest in the cigarettes industry (out of 6 companies).

I hate that the equity has decreased over the past year which makes me believe the increase in the ROE number was for the wrong reason. The fact that the AOCI continues to increase from quarter to quarter is pretty troubling for me. I only like decreases in equity if the company is buying back shares or if the retained earnings are being depleted due to increased dividends.

So here is where my trade comes in, I feel the stock is fairly valued right now based on 2016 earnings estimates and expensive on earnings growth expectations. There isn't much room to consolidate within the industry now with only six players left and lots of regulation creating a large barrier to entry, hence I believe the company has to begin looking outside into different vices to increase growth aside from the SAB situation the company is involved with.

I swapped out of T.Rowe Price (NASDAQ:TROW) for Altria during the portfolio change-out in late November, because I had a good gain in T.Rowe (8.49%) and felt that it might lag the rest of the market for the coming three months. So, hopefully I got out near the top in T.Rowe, and hopefully Altria beats it for the coming quarter. For now, here is a chart to compare how T.Rowe and Altria have done against each other and the S&P 500 since I swapped the names.

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It does look like the trade has worked out from the chart above and that is because the entire market has been crashing since November, other than the consumer safety stocks like Altria. I'm doing better in Altria than what is shown because I bought it on the lows of the day on November 24, 2015. The trade hasn't worked out well for me for now as I am actually down 0.24% on the name. I feel the name offers value below \$54 (midpoint of the 52-week range) so I won't be adding any shares to this portfolio till then.