Thursday, August 28, 2008

Staples vs Office Depot: ROE vs Price

There is much negativity surrounding Office Depot (NYSE: ODP), and with good reason. Margins and returns on capital have consistently been far less at Office Depot than they have at competitor Staples (NASDAQ: SPLS) and the company has a great many of its locations in both California and Florida, where the slow housing market has taken particular tolls on those local economies. Here's a look at the ROE of these two companies for the last few years:

Clearly, Staples has consistently outperformed as it has generated more income for each dollar it has invested. However, the disparity between the price/book values for these companies results in returns to current shareholders that are the exact opposite as those depicted above! With a Price/Book value of about .5, investors in Office Depot are buying the equity depicted above at about half price! On the other hand, with a Price to Book for Staples of almost 3, investors are paying a huge premium for those returns!

For the sake of illustration, here's a look at the 2007 returns for these two companies over the current market value of equity, rather than book value (which is what is depicted in the graph above):

Despite buying a mediocre company, you could get great returns relative to your investment thanks to the discount to book value at which it trades!

Of course, this doesn't necessarily mean Office Depot is a buy relatively to Staples. First of all, we're only looking at the past. If you believe that Office Depot's margins or returns will get worse from here relative to Staples' (and they already have since year-end 2007), then its returns will be worse than depicted here. Furthermore, if Office Depot management insists on expanding, despite the mediocre returns it receives for each dollar invested, then you risk losing the returns on market value (depicted immediately above) as that capital will be deployed and thus return a rate closer to the ROE depicted in the first graph. Finally, ROE can be inflated by using debt. Therefore, you'll want to make sure a company you invest in can safely cover its debt obligations.

Disclosure: Author has no position in Staples or Office Depot

1 comment:

Margin Of Buffett said...

"return on the market value of equity" is just a fancy way of saying earnings yield. Whenever people are talking about P/E, I'm going to refer to it as the return on the market value of equity. That way I can sound really smart without saying anything of intrinsic value ;)

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