# Financial Engineering Helped Boeing's Return On Equity Remain Flat

## Summary

Profit margins dropped by 7% from the previous quarter but were offset by the equity multiplier.

Net income dropped to the tune of 8%.

The average equity value has also decreased 8% thanks in large part to the company's share buyback program.

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:

Operating efficiency, which is measured by profit marginAsset use efficiency, which is measured by total asset turnoverFinancial 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 Boeing's (NYSE:BA) ROE because I've noticed that its ROE has remained flat(see table below)since the previous quarter and would like to see why.

 Quarter 2Q15 3Q15 4Q15 ROE 56.5% 76.0% 76.0%
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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 decreased by7% for the company from the prior quarter. We see that net income has dropped 7.9%and salesdecreasedby0.9%over the period. Nonetheless, profit margins decreased thanks to a big increase in net income and sales which means the flatness in ROE was partially due to the profit margin.

 3Q15 4Q15 % Change Q/Q Net Income ttm \$5,618 \$5,174 -7.9% Sales ttm \$97,009 \$96,114 -0.9% Profit Margin 5.8% 5.4% -7.0%
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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 slightly from the prior quarter. Total sales decreased while average assets decreased but at a higher rate. This portion of the equation tells us that the ROE move was somewhat related to the company's ability to make more money on their assets when compared to what they've done in the past.

 3Q15 4Q15 % Change Q/Q Sales ttm \$97,009 \$96,114 -0.9% Average Assets ttm \$98,518 \$97,321 -1.2% Total Asset Turnover 1.0 1.0 0.3%
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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 remained flat thanks to the decrease in profit margins but we still have to look at the equity multiplier because I believe the equity multiplier probably offset the profit margins.

An equity multiplier number of 14.3 is excessive for my taste but is par for the course among industrial related stocks. 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 clip, ultimately having a balancing effect on the profit margin drop and its impact on the ROE.

 3Q15 4Q15 % Change Q/Q Assets (avg ttm) \$98,518 \$97,321 -1.2% Equity (avg ttm) \$7,394 \$6,811 -7.9% Equity Multiplier 13.3 14.3 7.2%
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If we dig a little further we see that the equity value decreased (27%) over the past year primarily because of the share buyback program the company has in place.

 Stockholders' equity 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 Common stock \$5,061 \$5,061 \$5,061 \$5,061 \$5,061 \$5,061 Additional paid-in capital \$4,572 \$4,625 \$4,657 \$4,721 \$4,771 \$4,834 Retained earnings \$35,880 \$36,180 \$37,516 \$37,365 \$39,069 \$38,756 Treasury stock -\$22,349 -\$23,298 -\$25,513 -\$27,463 -\$28,898 -\$29,568 Accumulated other comprehensive income -\$8,653 -\$13,903 -\$13,815 -\$13,420 -\$13,263 -\$12,748 Total stockholders' equity \$14,511 \$8,665 \$7,906 \$6,264 \$6,740 \$6,335
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Conclusion

Boeing's return on equity is flat from the prior quarter and it is primarily flat because of the increase in the equity multiplier being offset by the decrease in the profit margins. When you multiply all the numbers together you get an ROE of76%, a move of0%from the previous quarter. This ROE makes Boeing the third highest in the Aerospace/Defense Products & Services industry (out of 41 companies).

The decrease in equity was primarily associated with increase the share buyback program the company has implemented over the past year. Eventually this will catch up to the fundamentals though as share buybacks aren't necessarily the best solution for lack of revenues or lack of margin increases. I don't really like increased financial engineering for the long-term and it speaks of what may be happening in the economy. I'm up on my investment but because of a potential broader economy collapse looming I've bought a put on my shares for some protection.