Sunday, October 12, 2008

Evaluating Management Using ROE

(I originally posted this article on The DIV-Net website on October 5, 2008)

Few factors are more critical in determining the potential success of a company than the quality of a firm's management. During economic and financial times like these, a quality management team can make the difference between success and failure. Certainly a company's dividend practice provides insight into management's anticipated view of future business prospects. Another variable that provides a clue to a company's anticipated prospects is return on equity (ROE) trends.

Return on equity provides information on how well management has invested the capital supplied by its shareholders. ROE is calculated by dividend earnings per share by book value per share than multiplying by 100 to convert to a percentage. In a recent article in BetterInvesting Magazine, it is noted adjustments may need to be made to equity to get an accurate measure of book value.
A company’s book value is determined by subtracting long- and short-term debt from the company’s total assets. It represents what a shareholder would get if the company and its assets were sold at cost. A note of caution about book values: If you’re dealing with a company that has most of its assets related to intellectual property or brands, the figure might be more art than science. The book value of drug patents, factory equipment and vehicle fleets are easily quantified. The book value of a brand isn’t so firm (though it would be foolish to say that brands such as Coca-Cola and McDonald’s don’t have value).
When companies use debt to finance growth, the debt level can inflate the ROE number due to the equity number in the denominator being smaller. Consequently, for firms that carry high debt levels, the resulting higher ROE may not be an effective gauge of management effectiveness. When evaluating the ROE, the return figure should be evaluated on a trend basis as well as compared with its peers.

In general, a higher ROE means the company is generating capital with its existing assets. This ability to generate capital internally means the company is less likely to issue more equity (dilutive) or take on more debt. The additional capital that is generated can then be used for business expansion, stock buybacks and/or dividend increases.

Additionally, I published a post on The DIV-Net website today that covers another management evaluation tool: reviewing the shareholder letter. In addition to the detail on the shareholder letter review, the post contains some advice from Warren Buffett on potential expectations for the coming weeks ahead.


Measuring Management by Return on Equity ($)
By: Michael Maiello
September 2007

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