|PRETAX PROFIT/CAPITAL EMPLOYED vs. ROE.|
In a similar vein to what I wrote in my Message #463, regarding "preaching to the converted" etc ..., I thought I’d detail the following regarding the use of the ratio PRETAX PROFIT/CAPITAL EMPLOYED.
I believe it’s always important to at least know the following in one’s attempt to analyse companies ...
1) the "in’s and out’s" of what one is using,
2) what it is using as its Formative data, and
3) what the result of its mathematical process is actually telling you.
If one doesn’t do that, and one relies solely on the fact that, if many are using something, then it must be right, there is always the risk that it could be a case of "garbage in, and garbage out".
But don’t get me wrong, the ROE ratio does not fall into that category.
However, I believe there are one or two aspects that need to be considered and taken into account ...
For those who may not be aware of it, the mathematical formula for ROE is :-
(Net Income / Shareholder’s Equity)x100, to get it into percentage form.
Let’s first consider the numerator, "Net Income".
This is the amount contained in the last line of a company’s Income Statement, and is sometimes referred to as the "Bottom Line".
When analysing anything about a company’s ability to generate Income, I believe it’s important that that Income represents, as far as possible, the normal business activity of the company. One doesn’t want to have to have "once-off" income, or costs, that may not be included in the future, as this would distort the end result.
Two examples of these "once-off" incomes or costs are "Extra-Ordinary Items" and "Tax Credits".
Sometimes a company may sell an asset, such as a property, and this would appear on its Income Statement in one particular period, but would not, necessarily appear in the future.
Therefore it would "inflate" the Bottom Line.
A "Tax Credit" could be a permitted assessed loss that a company may inherit from purchasing another company, and which the purchasing company could use to its advantage as a reduction to its own costs. Once again, when this "Tax Credit" runs out, the purchasing company’s Tax amount will increase and thereby reduce its Net Income.
Therefore, if one uses ROE ratios from web site tables, etc.., without first confirming what it contains, then you could be using a distorted number, giving you the wrong impression about a company’s ability to generate shareholder value.
Now let’s consider the denominator, "Shareholder’s Equity".
This consists of Share Capital + Reserves.
The "Share Capital" is that amount of revenue a company obtained from the original sale of its shares to the public. This is the only time that a company obtains money from its shares. After that, those shares are in the open market.
The "Reserves" are the ongoing accumulation of the Bottom Lines of the Income Statements, after any deduction for dividend payments. The "Reserves" can also be reduced if a company reports a Bottom Line loss, because that loss is deducted from the current "Reserve" number.
Once again, that "Reserve" number may be distorted by "E/O Items" etc.. as detailed above.
In addition, "Shareholder’s Equity" is not the only Capital available for use by a company.
That brings us to ....
PRETAX PROFIT/CAPITAL EMPLOYED :-
"Shareholder’s Equity" and "Net Income" could be replaced by other components of the Income Statement and Balance Sheet. And these other components could be less susceptible to "distortions".
Investors may want to consider a "Returns Ratio" based on "Pre-Tax Profit" from the Income Statement, and "Capital Employed" from the Balance Sheet.
I refer here, primarily, to Industrial type companies.
By using "Pre-Tax Profit" we do away with the aspect of possible "Tax Credits", and any non-taxable "Extra-Ordinary Items". One then only has to ensure that one is not including taxable "Extra-Ordinary Items".
PRETAX PROFIT is found in an Industrial company’s Income Statement just above the line that shows "TAXATION".
CAPITAL EMPLOYED is obtained by adding together the following items found in an Industrial company’s Balance Sheet :-
Share Capital + Reserves + Long Term Debt + Deferred Tax = CAPITAL EMPLOYED.
How that Capital has been "EMPLOYED" is defined as EMPLOYMENT OF CAPITAL, and is equal to :-
Fixed Assets + Current Assets – Current Liabilities = EMPLOYMENT OF CAPITAL.
Because one half of a Balance Sheet must equal the other half, i.e. "Balance", we have ...
CAPITAL EMPLOYED = EMPLOYMENT OF CAPITAL.
IMO the quickest way to get "Capital Employed" from the Balance Sheets of USA companies is to subtract "Current Liabilities" from "Total Assets". In other words …
TOTAL ASSETS – CURRENT LIABILITIES = EMPLOYMENT OF CAPITAL = CAPITAL EMPLOYED
By using "Capital Employed" one is incorporating that amount of Capital that a company has to "Employ".
The "Long Term Debt" and any "Deferred Tax" amounts are not part of the "Shareholder’s Equity" that forms the ROE denominator, but yet they are valid amounts of Capital that a company has at its disposal.
If you were to refer to the way UK companies present their Balance Sheets you will see that one half of their Balance Sheet consists of the "Capital Employed" I referred to above, while the other half consists of the "Employment of Capital”.
So my suggestion is to use the following percentage ratio, instead of ROE, and preferably to have it as big as possible :-
(PRETAX PROFIT/(TOTAL ASSETS – CURRENT LIABILITIES))x100, which is identical to ...
(PRETAX PROFIT/CAPITAL EMPLOYED)x100.