Tuesday, December 1, 2009

Returns Not Always What They Seem

Measuring a company's return on equity (ROE) is a useful way to determine whether management is justified in retaining earnings for further investment, particularly for a company with low debt levels. For example, if ROE is above 15%, in most cases the company should attempt to re-invest its profits in order to grow; if ROE is consistently under 10%, management should pay out earnings so that capital can be allocated to more profitable ventures. Sometimes, however, the ROE numbers don't tell the whole story.

Consider ROE numbers for EnviroStar (EVI), a distributor of laundry equipment, over the last several years:

Note that the company has had no debt over this period. Returns look decent, and then turn downward as the recession hit. However, the company generated mounds of cash over this period that it has not distributed. As such, ROE numbers are held down because of the large cash balance - but unlike in other cases we have seen, this cash balance is not required to run the business. Subtracting the cash balance from equity in the ROE equation yields the following adjusted ROE:
Clearly, even through this recession, the company has earned excellent returns on its invested capital, suggesting the company's prospects going forward are positive.

Of course, the cash balance is stuck in the business and therefore from the point of view of the shareholder, actual returns are of the order of those seen in the first chart above. However, the business is clearly a profitable one, as it can generate strong returns even with most of its capital sitting idle in the form of cash. Furthermore, if/when that cash is either put to work in earning returns or returned to shareholders, the business' owners will benefit. This is a company we have previously discussed as a potential value investment.

When considering ROE numbers, adjustments may be required depending on exactly what the investor is attempting to determine.

Disclosure: Author has a long position in shares of EVI


Jimmymac said...

I know you were looking at NWD (New Dragon Asia) in the past, but were concerned about the huge number of outstanding warrants and options. With the options and warrants now so far out of the money, does the 0.12 share price pique your interest? It looks cheap on Book value, net current asset basis, but it makes me wonder whether I am missing something. If something looks too good to be true and all that...

AKWON said...

Hey Saj, I do not understand why you subtracted cash. ROE is net income/ Average Shareholders Equity correct? So by subtracting cash we are assuming all cash came from selling common stocks for capital. I agree cash does affect return on equity indirectly because that cash could have been used to invest in additional assets or RD to improve sales or net income. However, to just subtract it directly from equity seems very arbitrary. I hope you can clarify this.

Saj Karsan said...

Hi jmcardle,

I haven't looked at NWD in a while. If I find anything interesting with it, I'll let you know!

Hi Akwon,

The idea was to determine the company's return on its invested capital, rather than just look at its standard ROE calculation. While the excess cash just sits there, the invested capital generates excellent returns, suggesting the company has the ability to earn better returns than the simple ROE calculation suggests. There is no assumption that "all cash came from selling common stock", but perhaps I'm not understanding what you're saying.

AKWON said...

I was just confused how you were able to just back out the cash from the equity to show ROE without cash. Since cash is an asset , I just thought backing cash out only would work for calculating adjusted return on asset.

AKWON said...

Ah I understand now, ROC and ROE are two different formulas measuring similar performances. Thanks.

Saj Karsan said...

Hi jmcardle,

I saw enough about NWD to devote a post to it! You can read it here