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South Africa: Sizing Up Companies On Return On Equity, Assets
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Business Day (Johannesburg)
COLUMN
30 April 2008
Posted to the web 30 April 2008
Ben Temkin
Johannesburg
IN ASSESSING a company, return on equity is an important investment fundamental. This return is the company's profit after tax as a percentage of its average shareholders' funds.
The shareholders' funds are the capital invested in the company, their equity. Clearly, the after-tax profit is the return on equity.
Looking at return on equity gives me an opportunity to write a few of my promised words on last year's annual report of Bell Equipment, one of the 10 counters in the Private Investor portfolio.
Bell's return on shareholders' funds (equity) is one of the key ratios printed on page 11 of the report. For the financial year ended December 31 2007, the return was 31%, and in 2006 it was 29%.
Another key ratio is return on total assets -- the percentage return of operating profit on average total assets (excluding cash).
Both these returns have been calculated from two averages calculated from the company's internal data. This is a good thing, as it saves the reader having to make an approximate calculation, which I, for one, have to do when I use the return on assets managed model.
In that model, I use year-end figures of equity, not averaged. I also use year-end assets -- not averaged -- and include cash.
While I would use averages in both cases, the returns on the model would differ from the company's. This is because the model employs two important efficiency ratios. The first is the ratio of revenue (sales) to assets, which is called the asset turn. I'll return to the second ratio, that of assets to equity, later when I will also explain why interest paid/received is ignored in the model.
The ratio of sales to assets -- the asset turn -- is not directly comparable from one industry to another. A company such as Bell has to invest heavily in plant and equipment to make its products for sale in the market. Pick n Pay, by contrast, is retailing products that have already been made. It does, of course, have to invest in assets; its latest Gauteng warehouse facility is a prime example.
In its 2007 financial year, Bell's asset turn, according to the model, was 1,60. In Pick n Pay's financial year ended February 29 2008, its asset turn was 5,28.
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Bell's operating margin or return on sales (pretax and interest profit as a percentage of revenue) was 10,68%. Pick n Pay's margin was 3,09%.
The return of assets, in the model, is the product of the asset turn and the operating margin. Bell's return on assets (1,60 x 10,68%) was 17,14%. Pick n Pay's return on assets (5,28 x 3,09%) was 16,31%.
Applying this form of fundamental analysis strictly, the return on sales or operating margin should be based on net operating profit after tax and interest. This return is then a cash-flow return. The model, because it excludes both interest and tax, gives a direct comparison of efficiency of asset management although year-end asset figures, rather than averages, were used. The end results, return on assets managed, were well above average for both companies.
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