Calculate Management Effectiveness Ratios

Even with the best products or services, companies have trouble delivering strong long-term growth unless their management makes sure that everything operates effectively and efficiently. Management effectiveness ratios compare financial measures from company financial statements to evaluate management performance. Of all the fundamental criteria that long-term investors consider, one of the most important is return on equity (ROE), which is a basic test of how well a company's management uses its money—are they increasing the overall value of the business at an acceptable rate? Return on assets (ROA) takes another view of management's effectiveness by illustrating how much profit the company earns for every dollar of its assets, such as money in the bank, accounts receivable, property, equipment, inventory, and furniture. One reason to consider ROA as well as ROE is that the latter can make high-debt companies look more effective than low-debt firms with the same earnings and assets.

Evaluating Return on Equity

Calculate ROE with the formula in .

Example 1. Formula for ROE

% Return on Equity = (Annual Net Income / Average Shareholders' Equity) * 100

Understanding Equity

The concept of equity is sometimes hard to grasp, so here's a brief lesson. Simply defined, shareholders' equity is the difference between the total assets and total liabilities of a company. It's an accounting convention that represents the assets that a business has generated in its lifetime from two sources:

Capital invested in the company by its owners

Profits generated by the company over the years that are retained and reinvested in the company (also called retained earnings)

Fundamental analysts consider company assets that don't have corresponding liabilities to be equity generated by the skill of company management. The higher and more consistent the returns that management generates on money invested in the company, the better off shareholders will be.

You can find net income, also known as net earnings, on a company's income statement, which is a financial statement required in an annual 10-K SEC filing. Shareholders' equity appears at the bottom of a company's balance sheet, which is also in the 10-K report.

shows a simplified example of Home Depot's 2003 financial statements, created with data obtained from the Home Depot web site (http://www.homedepot.com). First, identify net income near the bottom of the income statement (listed as Net Earnings in this case).

Table 0. Home Depot financial statements

Income statement (in millions)

Balance sheet (in millions)

NET SALES 58,247

Cost of Merchandise Sold 40,139

GROSS PROFIT 18,108

Total Operating Expenses 12,278

OPERATING INCOME 5,830

Interest Income (Expense):

Interest and Investment Income 79

Interest Expense (37)

Interest, net 42

EARNINGS BEFORE PROVISION FOR INCOME TAXES 5,872

Provision for Income Taxes 2,208

NET EARNINGS 3,664

ASSETS

Total Current Assets 11,917

Property and Equipment, at cost 20,733

Less Accumulated Depreciation & Amortization 3,565

Net Property and Equipment 17,168

Notes Receivable 107

Other Assets 244

TOTAL ASSETS 30,011

LIABILITIES AND STOCKHOLDERS' EQUITY

Total Current Liabilities 8,035

Long-Term Debt, excluding current installments 1,321

Other Long-Term Liabilities 491

Deferred Income Taxes 362

STOCKHOLDERS' EQUITY

Common Stock, par value $0.05; authorized:

10,000 shares, issued and outstanding 2,362

Shares at 2/ 2, 2003 118

Paid-in Capital 5,858

Retained Earnings 15,971

Accumulated Other Comprehensive Loss (82)

Unearned Compensation (63)

Treasury Stock, at cost, 69 shares

at 2/ 2, 2003 (2,000)

Total Stockholders' Equity 19,802

Then, look at the balance sheet and find shareholders' equity at the very bottom. Home Depot calls it Total Stockholders' Equity.

Using the formula in , you can calculate Home Depot's ROE.

Example 2. Calculating Home Depot's ROE

Home Depot's ROE = $3,664 / $19,802
                 = 0.185 or 18.5 percent

Home Depot's ROE is 18.5 percent, and you might be thinking "So what?" Think about the value of your home, your portfolio, or your business. If you were to increase its value by 18.5 percent in a year, you would be doing quite well. That's a much better return than you would receive from a bank savings account, for instance.

Some professional investors invest only in companies with a ROE higher than 15 percent. This guideline assures that company management has so far been effective in building up the value of their company. Home Depot exceeds this by a comfortable margin.

As with many other financial ratios, you can learn more about a company by comparing its ROE to its historical trends, as well as to other companies in the same industry. First, take a look at how Home Depot's recent results compare to its past.

In a spreadsheet, it's easy enough to calculate ROE for the past five years, as shown in . EdgarScan (http://edgarscan.pwcglobal.com) is a good source of historical SEC filings already formatted in Excel spreadsheets. Simply isolate net income and shareholders' equity from each annual 10-K filing and add the ROE calculations, as shown in Examples and .

Example 3. Excel function for ROE

Annual ROE (cell B4) = B2/B3

Figure 1. Calculate ROE for several years to look for trends

Example 4. Excel function for the five-year average ROE

5-year Average ROE (cell G4) = AVERAGE(B4:F4)

TIP

In , the formula in cell B4 was copied to cells C4 through F4. The cells are formatted as a percentage to one decimal point.

With these calculations, you can evaluate Home Depot's past performance in detail. The company's ROE has been fairly stable over the past five years. The company recovered from a downward trend in 2001 and 2002, which is a good sign. It's not unusual to see some fluctuation in ROE from year to year, but well-managed companies produce fairly stable results over the long term. Steadily rising ROEs are desirable, but that can't go on forever. Eventually a company's ROE will stabilize or start to fall slightly, which might not be negative if a company is maturing or receding from extraordinary performance levels.

Calculating a company's long-term average ROE can help smooth out short-term fluctuations and help you evaluate the stability of the ROE. Home Depot's most recent results exceeded its five-year average, which is what you want to see. If ROE declines for three or more consecutive years, you should research the company to understand the reasons for the fall. For example, cyclical companies by their nature see lower earnings as they reach the bottom of their cycle, so their ROEs trend up and down with the economic cycle.

ROE is another measure that you should compare within a company's peer group. The MSN Money web site (http://money.msn.com) calculates return on equity for you, and shows average ROE for the company's industry and the overall market. Enter the ticker symbol of the stock that you're studying and click Go. On the stock page, click Financial Results, then Key Ratios in the navigation bar, and then click the Investment Returns link, as shown in .

Figure 2. MSN Money offers ROE data and industry comparisons

In , you'll notice a ten-year chart of a company's ROE where it's easy to see that the company's management has been doing its job well. In the table below the graph, you can also see that MSN Money calculates Home Depot's 2003 ROE as 18.4 percent. Small differences between this figure and the number calculated from SEC filings is likely due to rounding. Home Depot's ROE is somewhat below the industry average of 19.3 percent, but it's well above the S&P 500 average of 9.6 percent and the ROE guideline of 15 percent.

The Return On Equity (5-Year Avg.) a few lines down in the table is more telling. Here, Home Depot's performance is even better with an average ROE of 17.9 percent compared to the industry's 17.0 percent, and 12.1 percent for the S&P 500.

Five-Year Industry Averages for Return on Equity and Return on Assets (1998-2002)

Evaluating Return on Assets

Because ROE only compares net income to shareholders' equity, a company that has raised working capital from bonds and borrowing might show a higher return on equity than a competitor without being any more effective at putting the shareholders' equity to work growing the company. Return on assets can help you understand how well a company uses debt as well as shareholders' equity.

You'll find a company's total assets on its balance sheet and can calculate ROA, as shown in .

Example 5. Formula for ROA

% Return on Assets = (Annual Net Income / Total Assets) * 100

Using the data from Home Depot's financial statements in , you can calculate its ROA, as shown in .

Example 6. Calculating Home Depot's ROA

Home Depot's ROA = $3,664 / $30,011
                 = 0.122 or 12.2 percent

Professional investors won't often consider stocks with ROA lower than 5 to 8 percent, so Home Depot's management has exceeded that standard. As with ROE, you should evaluate trends in ROA, and compare a company's ROA to its competitors and the market in general. A stable ROA over the years indicates that management is effectively managing its total resources to generate profits for the company. Looking at Home Depot's history in a spreadsheet (see ), you can see that the company's ROA has been consistent over the past few years.

Figure 3. Examine ROA over a period of five years to check the company's trend and average

ROA varies significantly by industry, as shown in the sidebar on industry average ROE and ROA. An automobile manufacturer requires a huge amount of assets—factories, materials, and parts—to build those SUVs that are so popular. Software companies, on the other hand, don't need big manufacturing plants to turn out their products—after they develop a program, they just stamp out software CD-ROMs, package them, and ship them to customers. They might even outsource those tasks to reduce the employees and buildings they need.

To compare Home Depot's 12.3 percent average ROA to the industry, refer to MSN Money. shows that the company's ROA is better than the industry average of 10.5 percent and worlds better than the 2.0 percent average of the S&P 500.

—Douglas Gerlach