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Return on Incremental Equity

|Includes: 3M Company (MMM)

 There are many ways to measure a company’s performance: Return on Equity, Return on Capital, Return on Invested Capital, Return on Assets. None of these measures, on their own, is enough to be relied upon wholly, as each is a simplification the business and may mask the truth underlying the performance. Nevertheless, they present a good starting point. Let’s look at an often overlooked metric, Return on Incremental Equity.

Return on Incremental Equity considers the total increase in equity over a period of time and what management has done with this reinvested equity. The reason we want to look at this is that, if we simply look at the increase in earnings, this may mask the fact that earnings have increased less than the increase in equity used to generate those earnings. In other words, management has reinvested at a lower return than management had previously been earning. We want to ensure that management is putting our capital to good use.

Let’s look at 3M (MMM). In 2000, 3M reported shareholder’s equity of $6.9 billion. In 2009, $13.3 billion, an increase of $6.4 billion. We then turn to the income statement and see that earnings in 2000 were $1.86 billion, and in 2009, $3.2 billion, an increase of $1.34 billion.

So, to generate an additional $1.34 billion, the company reinvested $6.4 billion. Dividing the incremental return by the incremental equity, we calculate that 3M had a ROIE of approximately 21% – very good indeed.

Now, we might want to look at how much 3M has paid out in dividends and how much gets reinvested. The reinvestment rate gives an idea of how much we can expect earnings to grow. For the 10 year period, 3M earned net income of 28.488 billion, and reinvested $6.4 billion, for a reinvestment rate of 22.4%.

Reinvesting 22.4% of earnings at a 21% ROIE gives us the idea that earnings should grow at 4.72% (= 0.224*0.21), hardly anything to get excited about. Why not reinvest a greater percent of earnings? It could be that management simply doesn’t have other uses that would generate a 21% return.

ROIE is a good measure to consider when evaluating the long-run track record of a company and management’s ability to put reinvested cash to work at a high return, rather than simply empire building.

 

Author Disclosure: At the time of publication, the author DOES NOT have a position in securities of this company.



Read more: Return on Incremental Equity | Frankly Speaking http://www.frankvoisin.com/2010/11/10/return-on-incremental-equity/#ixzz172GSpFW5 
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