Financial ratios are often used to sell a point to the investing public. The internet is full of flashy sounding articles on low Price-to-Earnings (P/E) stocks to buy now or high Return-on-Equity (ROE) stocks with great potential. Using a financial ratio, like P/E or ROE in isolation and not considering other metrics can lead to costly mistakes. Additionally, an investor needs to understand what drives these ratios higher or lower and how these drivers can potentially be manipulated to improve reported results. This article will discuss a popular financial ratio; the Return-on-Equity (ROE), its drivers and the pitfalls of following it blindly. ROE is defined as:
Since ROE increases as net income increases per dollar of shareholder equity, conventional wisdom is that a larger ROE is better.
The figure below shows ROE over the past 8 years for Boeing (BA). During this time frame, ROE has increased from just fewer than 20% to well over a staggering 100% (note that shareholder equity was negative in 2008 so ROE is not shown for that year). This is an extremely high number considering the historic average ROE of S&P500 stocks is somewhere around 14.1% (Pzena Investment Management 2nd Quarter 2009 Commentary).
To get a better perspective, the following figure compares the BA's ROE with several of its industry peers. While BA's ROE is high, it is still dwarfed by Lockheed Martin's (LMT) based on its most recent 10-K filing. Clearly, if someone is running scans purely based on the highest ROE, both BA and LMT would pop-out as winners. But, what is driving these ROE's to such high levels? Let's dig a little deeper.
To answer this, the equation for ROE can be rewritten in the so called DuPont form (see for example CFA Level I Study Guide: Financial Ratios - Return on Equity and the DuPont System):
This shows that management can increase ROE in three ways.
- increase the net profit margin (Net Income/Sales)
- increase the asset turnover ratio (Sales/Assets)
- increase the leverage ratio (Assets/Equity)
The latter term can be a source of investor angst. Leverage is not necessarily a bad thing; when times are good, leverage means profits and magnified for the shareholder. However, there are two sides to this coin; in bad times, losses are also magnified for the shareholder.
The figures below plot these three 'knobs' for BA over the past eight years. Net profit margins have increased nicely since the financial crisis of 2008, but still fall within historic norms. This partially answers why ROE increased significantly from 2009-2010, but is not the full story. In recent years, the asset turnover ratio has been trending downward which actually counteracts some of the gains achieved by the net profit margin.
The final figure shows BA's leverage ratio over time. It has increased by over a factor of four since 2004. Hence, this deeper look shows BA's massive increase in ROE is driven primarily by an increase in the leverage ratio and perhaps excess debt as opposed to an efficient use of assets or improvements in profit margin above historic levels. This is not enough information to say that BA is not investment worthy. More information is needed to draw a conclusion, but this example shows how ROE can be tricky as a single indicator of profitability.
What about LMT? What is driving their ROE of over 200%? What is driving the ROE of the other industry peers? The table below helps answer these questions and is based on the company's most recent 10-k filings.
An interesting trend is seen. Both LMT and BA have massive amounts of leverage and the lowest net profit margins compared to their peers, but the highest ROE! Clearly the leverage ratio is driving ROE. As mentioned previously, leverage will magnify profits (losses) when times are good (bad), but an investor needs to know when a company has turned the leverage ratio 'knob' past 10!
More work is needed to assess shareholder value of BA and LMT. Further ratio analysis should at least include a review of liquidity and solvency ratios and perhaps an intrinsic value analysis. Relying on ROE as the sole basis of an investment decision is not much better than the proverbial 'dart board and the monkey'.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.