McGraw-Hill Has A Sky High Return On Equity

| About: S&P Global (SPGI)

Summary

Net income and the equity multiplier values helped increase McGraw-Hill's return on equity.

The boost to the equity multiplier number was thanks in part to the company's share buyback program.

The company has great earnings growth expectations and I would applaud any increase to the 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 margin Asset use efficiency, which is measured by total asset turnover 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 McGraw-Hill Financial's (NYSE:MHFI) ROE because I've noticed that its ROE has sky rocketed(see table below) since the previous quarter and would like to see why.

Quarter

2015-09

2015-12

ROE

10.1%

214.5%

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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 1733% for the company from the prior quarter. We see that net income has increased 1763% and sales increased 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. If you're wondering why there was such a dramatic increase in the net income it is because there was a massive charge to SG&A in the fourth quarter of 2014 which dropped the net income number for the trailing twelve month used to calculate the 3 rd quarter 2015 net income value.

3Q15

4Q15

% Change Q/Q

Net Income ttm

$62

$1,155

1763%

Sales ttm

$5,229

$5,314

2%

Profit Margin

1.2%

21.7%

1733%

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 slightly from the prior quarter. Total sales increased while average assets increased but at a higher rate. 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.

3Q15

4Q15

% Change Q/Q

Sales ttm

$5,229

$5,314

2%

Average Assets ttm

$6,599

$6,952

5%

Total Asset Turnover

0.79

0.76

-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 12.9 is excessive for my taste but is par for the course among financial 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 increased and equity has decreased, ultimately having an increasing impact on the ROE.

3Q15

4Q15

% Change Q/Q

Assets avg ttm

$6,599

$6,952

5%

Equity avg ttm

$612

$539

-12%

Equity Multiplier

10.8

12.9

20%

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If we dig a little further we see that the equity value decreased (60%) over the past year primarily because of the share buyback program the company has in place.

Stockholders' equity

2014-12

2015-03

2015-06

2015-09

2015-12

Common stock

$412

$412

$412

$412

$412

Additional paid-in capital

$493

$421

$435

$441

$475

Retained earnings

$6,946

$7,166

$7,438

$7,592

$7,636

Treasury stock

-$6,849

-$6,867

-$7,011

-$7,234

-$7,729

Accumulated other comprehensive income

-$514

-$593

-$511

-$553

-$600

Total stockholders' equity

$488

$539

$763

$658

$194

Click to enlarge

Conclusion

McGraw-Hill's return on equity is higher from the prior quarter and it is primarily higher because of the increase in the profit margin and equity multiplier. When you multiply all the numbers together you get an ROE of 214.5%, a move of 2017% from the previous quarter. This ROE makes McGraw-Hill the second highest in the business services industry (out of 85 companies).

The decrease in equity was primarily associated with increase the share buyback program the company has implemented over the past year. This has been proven to be a good move on management's part because the company has great near- and long-term earnings growth projections.

I actually initiated my position in the company in late February 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 $93 (which is the midway point of the 52-week range). I never like to dive full bore into a name, I always buy in increments.

I swapped out of Altria (NYSE:MO) for McGraw-Hill during the portfolio change-out in the first quarter of 2016 because I had a good gain in Altria( 6.1%) and felt that it might lag the rest of the market for the coming three months.

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The chart above compares how Altria and McGraw-Hill have done against each other and the S&P 500 since I swapped the names. It does look like the trade has worked out from the chart and that is because financial related companies have caught a bid from February. I am actually up 17.7% on the name because financials have been screaming higher since Jamie Dimon bought his own shares back in February. For now I'm not making purchases in the name because I have a great gain and don't want to increase my cost average.

Disclaimer: This article is in no way a recommendation to buy or sell any stock mentioned. This article is meant to serve as a journal for myself as to the rationale of why I bought/sold this stock when I look back on it in the future. These are only my personal opinions and you should do your own homework. Only you are responsible for what you trade and happy investing!

Disclosure: I am/we are long MHFI.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.