# Eaton Vance Has An Increasing Return On Equity And Stock Price

## Summary

Profit margins increased by 15% from the previous quarter.

Retained earnings continue to increase but accumulated other comprehensive income has decreased.

The stock is up in a straight line lately but is still a value under \$35.

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 (NYSE:IBM), Boeing (NYSE:BA), or Altria (NYSE:MO) 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 (NYSE:DD) 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
Click to enlarge

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 Eaton Vance's (NYSE:EV) ROE because I've noticed that its ROE has increased (see table below) since the previous quarter and would like to see why.

 Quarter 2015-10 2016-01 ROE 36.5% 41.4%
Click to enlarge

Operating Efficiency

As mentioned earlier, operating efficiency is profit divided by 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 15% for the company from the prior quarter. We see that net income has increased 13% and sales decreased by 2% over the period. Nonetheless, profit margins increased thanks to a big increase in net income which means the increase in ROE was partially due to the profit margin.

 2015-10 2016-01 % Change Q/Q Net Income ttm \$226 \$255 13% Sales ttm \$1,404 \$1,381 -2% Profit Margin 16.1% 18.5% 15%
Click to enlarge

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 decreased from the prior quarter. Total sales decreased while average assets increased. This portion of the equation tells us that the ROE move was not related to the company's ability to make more money on their assets when compared to what they've done in the past.

 2015-10 2016-01 % Change Q/Q Sales ttm \$1,404 \$1,381 -2% Average Assets ttm \$1,802 \$1,852 3% Total Asset Turnover 0.78 0.75 -4%
Click to enlarge

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 but we still have to look at the equity multiplier.

An equity multiplier number of 3.01 is decent for my taste and excellent for a financial company. 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 increased and equity has decreased, ultimately having a positive impact on the ROE.

 2015-10 2016-01 % Change Q/Q Assets (avg ttm) \$1,802 \$1,852 3% Equity (avg ttm) \$620 \$616 -1% Equity Multiplier 2.91 3.01 3%
Click to enlarge

If we dig a little further we see that the equity value decreased (2%) over the past year primarily because of the decreased accumulated other comprehensive income.

 Stockholders' equity 2014-10 2015-01 2015-04 2015-07 2015-10 2016-01 Retained earnings \$682 \$656 \$676 \$674 \$680 \$664 Accumulated other comprehensive income -\$27 -\$51 -\$42 -\$56 -\$60 -\$74 Total stockholders' equity \$655 \$606 \$635 \$618 \$620 \$591
Click to enlarge

Eaton Vance's return on equity is increasing from the prior quarter and it is primarily increasing because of the increase in net profit margins and the equity multiplier. When you multiply all the numbers together you get an ROE of 41.4%, a move up of 14% from the previous quarter. This ROE makes Eaton Vance the sixth highest in the asset management industry (out of 164 companies).

Conclusion

The decrease in equity was primarily associated with accumulated other comprehensive income which declined. 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.

So here is where my trade comes in, I feel the stock is undervalued right now based on next year's earnings estimates and fairly valued on earnings growth expectations. I actually initiated my position in the company in late December and have been pretty happy with the purchase thus far. But I never look to initiate a full position in a name immediately and think the stock is a buy as long as it is below \$35 (which is the midway point of the 52-week range). It is still under \$35 but I'm not adding to my position because I have a positive return on my investment thus far.