Qualiport

Bruce continues to look at return on equity

Over the past couple of weeks, there have been enough reams of paper and megabytes of space devoted to the so-called stock market correction to kill another Brazilian rainforest and to keep the server industry in business for the next few years. So, as promised, today we revert back to our How To Value Shares series. In the last instalment, way back on Friday 31st July, we started looking at return on equity. A lot of Footsie points have flowed under the bridge since then (it closed that day at 5837), but nothing has changed about the mechanics of stock analysis.

We follow the hypothetical example of Ally's Abode, as featured on Friday 31st July, through as we go deep underground in our search to understand return on equity. You will need to read or re-read that previous edition, as the story moves straight on from there. Onward march valuation soldiers...

Purchased Goodwill

Let's say another company sees potential in Ally's one house business and offers to buy it at the end of year 1 for £200,000 cash. Ally thinks this is a pretty good deal, since he bought it for £150,000 and has retained £12,000 in the business, and quickly accepts the offer.

The new buyer, Bernie, thinks the house business is worth £200,000 to him, even though its book value is only £162,000. The fair value of the house, as determined by an independent surveyor, is £170,000. Bernie plans to subdivide the house, add a few more bedrooms and a few more students, and receive £20,000 income per annum after tax. His ROE clearly would be 10% (Net income of £20,000/Shareholders' equity of £200,000). Sounds simple. Up until the end of 1998, the transaction would be shown in the acquirer's (Bernie's) balance sheet as:

   
Assets    
One House                 170,000
    
Shareholders' Equity    
Share Capital             200,000  
Purchased Goodwill        (30,000)
                          170,000

Note that the book value of £162,000 is completely irrelevant when a business is acquired. It therefore follows that book value is of little consequence when valuing any company, as it usually doesn't reflect the underlying value of the business. Having said that, some companies can trade below book value, and some investors, including granddaddy of them all Benjamin Graham, would say at that point that the company represents value.

Calculating the ROE using net income divided by starting shareholders' equity as stated above gives us an ROE of 11.8% (£20,000/£170,000), much different from the 10% we calculated above based on the £200,000 purchase price. The difference all comes down to how you treat the purchased goodwill, which in this example appears in the balance sheet as a reduction in shareholders' equity.

Common sense says that the acquirer's ROE is 10%. Up until December 1998, Generally Accepted Accounting Practices (GAAP) allow UK companies to treat purchased goodwill as in the above example. To calculate the true ROE, a better definition would be:

Net Profit
-----------------------------------------
Shareholders' Equity + Purchased Goodwill

   
             20,000 
=    -------------------  = 0.10 or 10%.
       170,000 + 30,000

Just to confuse things further, from the beginning of 1999, a new accounting Financial Reporting Standard (FRS10) directive comes into force. Many companies are adopting FRS 10 when reporting their 1998 results and now capitalise purchased goodwill on the face of the balance sheet, as an intangible asset (meaning an asset you can't physically touch). The company then can amortise (or write off against profits) it in equal instalments over a period of 20 or more years, or it can choose not to write it off at all. This latter policy can only be followed if an annual impairment test shows that the value of the purchased goodwill hasn't fallen below the level it is being carried at in the balance sheet. Confused? It basically means that the same balance sheet as above would probably look like this when the accountants comply with FRS10.

  
Assets 
  
One House              170,000
Goodwill                30,000
Total Assets           200,000
  
Shareholders' Equity
  
Total Share Capital    200,000

At least that makes ROE far easier to calculate, and makes much better sense than writing off goodwill against shareholders' equity. Examples like this show just what confusing and even ambiguous accounting practises can mean to what should be a simple ratio calculation. Investors should always attempt to look through the mumbo jumbo and try to visualise any company's performance as if it where their own. I'm not going into any more detail on the inherently boring subject of purchased goodwill, but I hope this gives you an idea of what to look out for when calculating a company's return on equity.

In conclusion, ROE is effectively a measure of the efficiency with which a company employs shareholders' capital. It is also a measure of the percentage return to owners on their investment.

One final point before I leave ROE. The definition can be rewritten as:

   
ROE =  Net Profit          Sales                Assets
     --------------  x  -----------  x  -----------------------
         Sales            Assets         Shareholders' Equity

Simple algebra eliminates sales and assets from the numerator and denominator, leaving the classic definition of net profit divided by shareholders' equity. The reason the extrapolated equation is important is because the 3 levers of profit margin, asset turnover and financial leverage are the only ones a company has for controlling ROE. For more on this, and ROE in general, here's a link to Randy Befumo's five part series over at our US site's own Fool's School.

Now that we've got the theory out of the way, on Friday we will look at how to use ROE to value companies. See you then, by which time hopefully the returns from the Qualiport will have picked up!

All comments and thoughts, as usual, encouraged to the message boards.

Bruce Jackson (TMF Googly)

Qualiport Numbers

Today's Numbers            Date    12/08/98


         Change       Bid
          pence        £

RTO        0.01      3.48
EMAP       0.00     11.50
MKS        0.10      4.99
ULVR       0.05      5.80   


Rec'd       #    Stock      Buy       Now    % Change  £ Change

19/12/97  1565  Rentokil   2.55      3.48     36.5%      0.93 
17/04/98   337  EMAP      11.85     11.50     -3.0%     -0.35 
11/05/98   722  M & S      5.535     4.99     -9.8%     -0.55
17/07/98   595  Unilever   6.72      5.80    -13.7%     -0.92


19/12/97  1565  Rentokil  4,040.63  5,446.20   34.8% 1,405.57 
17/04/98   337  EMAP      4,043.37  3,791.25   -4.2%  -167.87
11/05/98   722  M & S     4,052.24  3,610.00  -11.1%  -449.46
17/07/98   595  Unilever  4,048.38  3,528.35  -14.8%  -597.38


Cash                                    67.82

Total                               16,443.30 


                Day    Month    Year    History

Qualiport       0.7%   -4.8%    33.0%    36.0%
FTSE 100        0.5%   -6.4%     6.4%     8.8%
FTSE All Share  0.4%   -6.1%     6.6%     8.8%