The Truth Behind Accenture’s High Return on Equity

After reading an article in BusinessWeek (online dated July 2, 2007) about the top 100 tech companies ranked by ROE, I discovered that Accenture’s (ACN) ROE is 66%. I then calculated its ROE for the last five years (as of August 31 for the corresponding year) and, to my surprise, I found that the ROE has reduced over the period of five years, following its astonishing high level of 131% on August 31, 2002.

The following table gives a snapshot of some important numbers pertaining to its ROE for last five years.

The reason I have calculated two ROEs is to demonstrate the effect of a dual share class that has given rise to minority interest; this amount is significant as it distorts the net income. This is evident from the fact that the ROE calculated by considering net income before minority interest varies from 75% to 131%, whereas the other ROE (calculated just from net income) varies from 51% to 55%.

NOTE : Return on equity (ROE) is defined as (net income / shareholder’s equity)

A close look at the different components of book value reveals the following:

From the above table three things are clear:

1. The high ROE in 2002 was because of a large deficit in retained earnings that in turn reduced the book value. This started in the year 2001 ($1.43 billion deficit) when the company broke from its traditional partnership type organization and became public. The table shows that this was reduced in subsequent years and in 2006 was $1.6 billion

2. Additional paid in capital has decreased since 2002 and treasury stock has increased since then. Both together have decreased the book value.

3. As the company’s net income before minority interest grows and its effect of minority interest is reduced, so the difference between two ROEs will also be reduced.

The above figure shows the amount of treasury shares held by the company, a figure which has been changing every year. As a conservative estimate, let us assume that the number of treasury shares would have remained 6 million on August 31,2006 instead of 36 million. The amount against treasury shares would have been reduced from 869 million to 144 million. This would have increased the book value by at least 725 million, thus making the book value around $2.6 billion, making the two ROEs 37% and 53% (ROE with net income before minority interest) instead of the present 51% and 75%.

Conclusion

So, if you are comparing Accenture to its competitors and are impressed by its ROE, you might want to look at the details of its competitors’ book value and make sure you are comparing apples to apples.

Comments

[Ciba Gator:]

Dan,
In the interests of my sanity I will not harp on about how you have mangled the share count/class structure of ACN's shares. I will just say that when calculating your ROE figure, you have to reduce equity by the value of the minority interest equity value when using the lower share count. That aside....

If I understand the conclusion of your analysis correctly (please correct me if I am wrong), you are saying that if Accenture had not bought back any shares since 2004 (thereby increasing treasury shares and reducing equity), then their ROE would be lower. Is that right? Two thoughts:

1) You neglected to add back interest income on the substantial amount of cash used to buy back shares. If you are making the assumption that treasury shares should remain at 6 million, then you have to assume that the cash used to buy those 30 million net shares would be throwing off substantial interest income, which would boost ROE.

2) OF COURSE if the company lets cash sit in a bank account its ROE will be lower than if it gives that cash back to shareholders. Classic capital allocation decision--maximize returns on capital. If they could take that cash and invest it in business operations or investments that would be accretive to ROE, then they would not buy back shares. But since the company does not need cash to run its operations, they give it back to shareholders.

A little too much analysis to come to a very basic answer.

2007 Jun 26 01:05 PM

[Dayanand Me...:]

1. Can you please make an estimate about interest income. This would add up to the numerator.

2. The cash that wouldnt have been used to buy back shares would add up to the book value increasing the denominator.

It would be interesting to see how the numerator and denominator now compare.

2007 Jun 26 02:00 PM

[Ciba Gator:]

Best guess is that the reduction in Paid in capital would be a good approximation for cash spent, or $943 million. 4% interest rate? That leads to $38 million in income or call it $25 million after taxes.

You already grossed up the denominator -- that was the $725 million you calculated and added back to book value. So you need to add the approx $25 million to the numerator to complete your analysis.

That boosts ROE by 1%.

You never answered the question--is your conclusion from your analysis that Accenture's ROE would be lower if they didn't buy back stock?

2007 Jun 26 02:16 PM

[Dayanand Me...:]

Thanks for your calculations.....
so if Accenture would not have bought back the shares then the new figures would be as follows:

Net income $973 mn + 25 mn = $998 mn
Income before minority interest = $1,430 mn + 25 mn = $1,455 mn
Book value = $1,890 mn + 725 mn = $2,615 mn (adding $725 mn cash to the book value).

Therefore the new ROEs are

ROE (calculated for net income) = ($998 mn / $2,615 mn) = 38.16%
ROE (calculated for net income before minority interest) = ($1,455 mn / $2,615 mn) = 55.64%

I guess these are quite close to the figures I calculated in my analysis i.e. 37% and 53%.

Do I still need to answer the question if Accenture's ROE would be lower if they didnt buy back stock.....the figures are in front of you .....38% and 55% (if they did not buy back shares) compared to the present figures of 51% and 75%.

But my bottomline was not to prove this point, it was just to make aware to the investors that if they are comparing Accenture's ROE with some other company's ROE then they should make sure they take a closer look at the structure of the book values of both the companies.

2007 Jun 26 03:45 PM

[Ciba Gator:]

I agree with your revised math.

I have no idea why you are suggesting that investors look at the lower ROE figure when comparing Accenture's ROE to other companies. Are you saying that the share buybacks are irrelevant or unusual in nature?

2007 Jun 26 03:54 PM

[Dayanand Me...:]

Sharebuybacks are neither irrelevant nor unusual. In fact they are very much relevant and we saw how it increased the ROE. My bottomline is as follows:

1. Let us say you are comparing Accenture with a company 'X'.

2. At the beginning of the year both have book value of $2bn. Accenture buys its own shares for $100 mn. And Company 'X' invests $100 mn in marketable securities.

3. Let us say by the end of the year the marketable securities and Accenture's stock appreciate by 10%.

So as far as an investor's point of view both have achieved the same result. But the ROE of Accenture is more than company 'X' because its book value has been reduced by 100 mn.

For calculating the ROE it is assumed that both have same net income.

2007 Jun 26 06:00 PM

[Ciba Gator:]

Interesting angle, but I disagree with your conclusion that "from an investor's point of view both have achieved the same result."

From an investor's point of view, Accenture has returned $100 million of capital to them. They can then reinvest that elsewhere. If the investor can get 15% returns on an alternate investment, then they are better off. Second, Accenture cannot (would not) invest in marketable securities that return 10% -- they must invest in high quality (safe principal) instruments. Accenture is not an investment company and has no business trying to obtain high yields from marketable securities.

Bottom line: Investors are very sensitive to ROE because they want companies to produce high returns on the equity that has been entrusted to them. By returning capital to shareholders via buyback and still earning the same net income (as you state above), Accenture will earn a higher ROE, which (and this is the Important Conclusion) will be VIEWED AS MORE VALUABLE BY INVESTORS than if the company earned income on marketable securities.

2007 Jun 26 06:10 PM

[Dayanand Me...:]

OK I might have been a little more aggressive about the 10% return on marketable securities....I guess 5% would be more realistic....

returning to our main discussion point of relationship between ROE and treasury shares. I tried hard to find a company that had an amount of $860 mn in treasury shares.

Do you know of any company that has this much amount in treasury shares?

2007 Jun 27 08:49 PM

[Ciba Gator:]

Many have that much or more. Try IBM, for instance.

2007 Jun 28 12:41 AM

[Dayanand Me...:]

After your reading your comment again....I thought of one point.....I guess the investor would also be interested to know as to how the money was returned.

For instance. If Accenture borrows $100mn and buys back its shares then actually its book value would be reduced by $200mn. Because it would also have an additional debt of $100mn.

So ROE of Accenture would increase by 10% because its book value now is $2bn - 200 mn. So just by changing its debt to equity ratio a company can increase its ROE.....

In fact this point can really be intersting if we consider the way Accenture's debt has changed over the years.

2002 10-K balance sheet
Current Liabilities : $3,327,062
Non current Liabilities :$1,193,864
----------------------...
TOTAL :$4,520,926
----------------------...

2006 10-k balance sheet
Current Liabilities : $5,816,482
Non current liabilities : $839,465
----------------------...
TOTAL : $6,655,947
----------------------...

Accenture's liabilities have almost increased by $2bn , on top of this they have bought back shares and returned money to investors.

2007 Jun 27 09:36 PM

[Ciba Gator:]

You might want to examine ROI as a better alternative to ROE.

"Debt" hasn't really increased at all--liabilities have increased (as have assets).

2007 Jun 28 01:00 AM

[Dayanand Me...:]

Ciba,
So what do u think about the retirement obligations, it is stated in Non Current liabilities section of the balance sheet. It has decreased from 753mn to 492 mn. But is still a big percentage compared to the book value of $1.89bn.

I tried to find an explanation in the footnote-10 as to how Accenture calculates its retirement obligations, but could not match the figure of $492mn. Let me know if you can figure out how they calculate the retirement obligations.

Thanks,
Dayanand.

2007 Jul 04 02:58 PM