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Dollars from Sense Part 3A

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Investing - Dollars from Sense

Written by Hugh McManus

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Chapter IIIA  The Stock Selection Guide—Part 2   What we’re going to cover In this section, we’re going to look at parts 2 and 3 of the stock selection guide.  Chapter 3A will look at section2; 3B will examine section 3.  Section 2 is an evaluation of management and looks at pretax profit expressed as a percent of sales, and the Return on Equity (ROE) or the return on invested capital.  These tools when used together give a great insight into the management of a company.  Section 3 is an evaluation of the PE ratio and the dividend yield.  These tools feed into section 4 of the SSG when it comes to predicting future stock price behavior.Section 2 of the Stock Selection Guide is a review of management.  This part of the SSG is probably the least well appreciated.  Many people think it an intrusion on the way to calculate future stock prices!  This section, is however, essential if one wants to round of the graphical analysis from Chapter 1.     A B C D E F G H YEAR Profit Tax Rate B/100 1 - C A/D Sales E/F G*100 1999 155.0 37.0 0.370 0.630 246.03 1344.3 0.183 18.3% 1998 137.7 38.0 0.380 0.620 222.10 1227.8 0.181 18.1% 1997 119.5 38.0 0.380 0.620 192.74 1021.7 0.189 18.9% 1996 106.8 38.0 0.380 0.620 172.26 928.7 0.185 18.5% 1995 87.0 35.9 0.359 0.641 135.73 758.1 0.179 17.9% 1994 69.3 36.0 0.360 0.640 108.28 628.2 0.172 17.2% 1993 53.8 35.5 0.355 0.645 83.41 476.2 0.175 17.5% 1992 39.3 34.6 0.346 0.654 60.09 371.2 0.162 16.2% 1991 26.6 35.9 0.359 0.641 41.50 320.6 0.129 12.9% 1990 19.9 36.7 0.367 0.633 31.44 260.3 0.121 12.1% Table 1 Calculation of pretax profit on salesThe Pretax Profit MarginThe first thing we determine is the pretax profit as a percentage of the revenues—this number is called the pretax profit margin.  The SSG states that it’s a percentage of sales.  The calculation is a little involved—if you use Value Line as a source.  Since we previously talked about the benefit of using Value Line, we continue to use it!The table above is a useful worksheet for this calculation.  The calculation in this section is pretty straightforward, and the numbers are taken directly from the Value Line report.We have ten years of historical revenue and profit information, the most recent year is 1999; the first column (the year) is completed.  We want to calculate pretax profit; however, Value Line provides information about net profit or as we called it when we talked about the income statement—net income.  You’ll just have to get used to different terms meaning the same thing.  Soon we’ll see how net profit and the tax rate (also found in Value Line) can be used together to generate the pretax profit.  If you look at the Value Line report for Clayton Homes, the Net Profit is found on the fourth line after the revenues.  The net profit for each of the past ten years is found in the second column (labeled A) in the table above.Let’s think through the following.  When we ran through the income statement, one of the very last expenses taken out was taxes.  The net income (or net profit) was $154,968—that’s the income after taxes.  If you knew that the tax rate is 37% and that the net income was $154,968, here’s how you’d find the pretax profit.So we know that the tax rate is 37%; that means you pay Uncle Sam 37% of your income and you keep the difference (100% - 37% = 63%); you get to keep 63%.  Or after taxes were taken out, you get to keep the net income—$154,968.  So, if $154,968 is 63% of something, what’s that something?  You calculate it as follows:                                                                            Equation 1Note: when you do math with something that’s a percentage, you always express it as a decimal.  So 63% becomes 0.63.  Here’s what we’ve done:                                                                Equation 2So the net income, divided by one minus the tax rate (expressed as a decimal) gives the pretax profit—the thing we’re looking for.  You can use this formula to convert the figures in Value Line into pretax profit.The last step is to calculate the pretax profit expressed as a percentage of sales (actually revenues).  Here’s how it’s done:                                   Equation 3Pretax profit divided by sales and expressed as a percentage is the pretax profit margin.We will use the table above to calculate the pretax profit on sales for Clayton Homes.  There are a lot of steps, and every step you need to calculate the statistic is shown explicitly.The tax rate (as a percentage) is entered into the appropriate spot in column B.  In column C, the number in column B is divided by 100—the tax rate is now expressed as a decimal rather than as a percentage.  In column D, one minus the tax rate (written in decimal for) is calculated.  Remember, we have to find out what one minus the tax rate is.  Finally, the pretax profit is calculated and shown in column E.  If you divide (1 – tax rate), which is column D, into the net income (column A) you get the pretax profit.So, we now have the pretax profit; we’re ready to calculate the pretax profit margin.  The sales figure (revenues) for each year is listed in the appropriate box in column F.  Column E is divided by column F and the result is written in column G.  That is, the pretax profit is divided by revenues; the result is written in the appropriate spot in column G.  Finally, the number in column G is expressed as a percentage by multiplying it by 100%.  The result of this multiplication is presented in column H.The results in column H are then transcribed into box 2A of the Stock Selection Guide; it follows soon!  You’ve now calculated the pretax profit margin.Why pretax profit?So why look at the pretax profit margin rather than after tax (net income).  Well, we’ll have a discussion about taxes next.  But the reason is simple.  Companies have control—or at least options—over expenses.  You can haggle with your employees and substitute stock options for salary.  The company can lease rather than buy; it can decide to fund through equity rather than debt.  There are choices at every point, but when it comes to paying taxes, there’s only one customer—the government.  By putting things on a pretax basis, you’re leveling the playing field.Clayton Homes has done a good job of expanding its pretax profit margin.  It’s climbed from 12% to 18% in just ten years.  Good job.  Keeping such margins steady or increasing is important.  Think of the old saying “a penny saved is a penny earned.”  Well, if your profit margin is 10%, a penny saved is a dime earned!  In other words, since 90% of the money you take in over the counter goes out as some kind of expense, if you wanted to generate that penny through revenues, you’d have to sell an extra dime of product.Let’s talk about taxes and deferred taxesI’ve mentioned it before, but it’s probably worth repeating here: depreciation has tax implications.  The earnings that a company reports to the IRS is not necessarily the same as those reported to shareholders.  Don’t be outraged; it’s simply the company you own working efficiently for you.When it comes to depreciation—and depreciation is probably the largest source of the discrepancy—the financial perspective on the use of assets is different from that of the IRS.  In fact, the IRS gives companies a break.  Here’s how.  The IRS allows a company to depreciate an asset faster than it is used up.  For example, if you own a reactor for making pharmaceuticals, it might have a useful life of 25 years.  For tax purposes, the device could be depreciated in 7½ years; for financial reporting purposes, the asset is depreciated over twenty-five years.Let’s say your company spent $25 million buying and installing a special widget production machine.  The useful life of the device is 10 years; however, the IRS allows you to depreciate if over seven (seven and one half).  Let’s say that you the company generates EBIT (earnings before interest and taxes) of $7½ million each year.  The tax liability (the tax rate is 40% in this example) for the company would be as follows:   1 2 3 4 5 6 7 8 9 10 EBIT 7500 7500 7500 7500 7500 7500 7500 7500 7500 7500 Depreciation 3572.5 6122.5 4372.5 3122.5 2232.5 2230.0 2232.5 1115.0 0.0 0.0 PTP 3927.5 1377.5 3127.5 4377.5 5267.5 5270.5 5267.5 6385.0 7500.0 7500.0 Tax paid 1571.0 551.0 1251.0 1751.0 2107.0 2108.0 2107.0 2554.0 3000.0 3000.0 Net Income 2356.5 826.5 1876.5 2626.5 3160.5 3162.0 3160.5 3831.0 4500.0 4500.0  So, we’ve just looked at the income statement for tax reporting purposes.  You can see from the second line that the government stacks depreciation expense in the early years.  Let’s look at what would happen if straight line depreciation could be used for tax purposes.   1 2 3 4 5 6 7 8 9 10 Tax paid 1571.0 551.0 1251.0 1751.0 2107.0 2108.0 2107.0 2554.0 3000.0 3000.0 Tax (other) 2000.0 2000.0 2000.0 2000.0 2000.0 2000.0 2000.0 2000.0 2000.0 2000.0 Difference -429.0 -1449.0 -749.0 -249.0 107.0 108.0 107.0 554.0 1000.0 1000.0  All the table above says is that for the first four years, the income tax burden is reduced because the IRS wants the company to use a different depreciation schedule.  The tax burden is roughly the same for the next three years ($107,000 isn’t a lot compared to other years!) and for the last four years, the tax burden is more.Here’s one way that accountants could balance the accrual principle with the requirements of the IRS.  The entry in the books for year one would look something the following:   Income tax expense     2,000.0       Income taxes payable       1571.0     Deferred income tax       429.0   In other words, for financial reporting purposes, income tax would be recorded as an expense of $2 million.  Income taxes actually paid would be $1.571 million, and a tax liability account would be set up and $0.429 credited to that account.  The liability would grow for four years, then, in year five when taxes paid is higher than taxes due, the liability would be reduced by this difference.  This account is called “Deferred Income Taxes.”  I have talked about tax being a liability in the sense that it is owned, but Deterred Income Tax is often an asset on the balance sheet of a company.Some estimation has to be done here about future tax rates and all that.  If it turns out that the estimates were wrong (and they will be!), then things are balanced out at the appropriate time.  Slight flaws in these estimates of what will happen in the future make could make the tax rate bounce around very slightly.  That’s one of the reasons why the tax rate never appears to the exactly the same from year to year.ROE: The next step is to calculate 2B—the return on equity or the percent earned on invested capital.  I believe that this number can be one of the most informative in the SSG.  I’ve provided another worksheet below for the simple calculation.This calculation is a breeze compared to figuring out the pretax profit margin.  You only need two numbers from Value Line: earnings per share and book value per share.  Book value per share is shareholders equity divided by the number of shares outstanding.  These numbers are found in the upper section of the number grid in Value Line.  EPS is often found on the third line down from the top.  Book value per share (BVS) is usually found about two or so lines under the EPS.  Dividing BVS into EPS and multiplying by 100 gives the return on equity (ROE).  The calculations are performed in the table below, with the ROE shown in column D.  A discussion on ROE follows.   A B C D YEAR Earnings per share Book value per share A/B C x 100% 1999 1.06 6.76 0.157 15.7% 1998 0.92 5.95 0.155 15.5% 1997 0.80 5.09 0.157 15.7% 1996 0.72 4.38 0.164 16.4% 1995 0.59 3.69 0.160 16.0% 1994 0.47 3.14 0.150 15.0% 1993 0.37 2.55 0.145 14.5% 1992 0.29 2.15 0.135 13.5% 1991 0.24 1.60 0.150 15.0% 1990 0.18 1.14 0.138 13.8% Table 2 Calculating Return on EquityReturn on Equity—a discussionI mentioned earlier that ROE provides a powerful insight into the management of a company.  A discussion on ROE will have echoes of the material covered when the balance sheet was discussed—and how a company is financed.  Both of these were touched on in Chapter I.Let’s get cracking.  We’ll revisit much of previous discussions, so skim if you want; however, it is useful to provide a context for ROE.  Now, the goal of a business is to generate financial gain from assets.  These assets could be tangible—cars, factories—or intangible—designing software, etc.  There are two ways to finance these assets: through debt or equity.  That is, you can borrow money or have someone buy part of the company for cash—this cash would then be used to finance the activities (operations) of the company.  ROE concerns itself with the assets financed by the owners of the company.  ROE is the return on the net assets of the company.  If you like, the return on the assets that the shareholders own, free and clear!  Net assets is the value of the assets after all liabilities have been subtracted away.  Owners equity, or capital, is the claim of the owners against the net assets of the firm.  Return on equity or return owners equity is                                   Equation 4People who have financed the corporation through debt (including preferred shares) have a defined rate of return: they might be promised a fix percentage on their investment.  ROE is a measure of the return that shareholders get on their investment.  Ultimately, the net income (less any dividends) transfers into shareholders equity—it becomes retained earnings.  ROE links the income statement and the balance sheet together.ROE can be broken up into constituent components.  The exercise of breaking up the ROE—though not essential to completing section 2 of the SSG—is not the less highly instructive.  This exercise shows the drivers of profitability for a corporation.  Breaking up the ROE can be found at the end of this chapter.ROE for Clayton HomesThe return on equity for Clayton Homes is provided in a table above.  The calculation for ROE differs from that discussed in the last section of this chapter.  In section 2B of the SSG, ROE is defined as follows:                                 Equation 5Earnings per share is net income divided by the number of shares outstanding, while book value per share is shareholders equity divided by the number of shares outstanding.                               Equation 6These two definitions of ROE are, in fact, equivalent.  Book value can also be called shareholders equity; earnings can be called net income.  ROE is called the percentage earned on invested capital in the SSG.  As you read through the relevant definitions in Chapter I, you can see that this definition is the same as ROE.Section 2 of the SSG for Clayton homes is below. Figure 6 Section 2 of the SSGThe first thing you might notice is that there are extra numbers—in fact there are eleven boxes per line!  The number in this eleventh box, which is 18.7 for % pretax profit on sales (PTP), is calculated by adding up the last five years (1995-99) and dividing this sum by five.  The same thing is done for ROE, where the value is 15.9%.  You’re looking at a recent five-year historical average and comparing the most recent result (for 1999) with that average.  The figures reported for 1999 were within 0.5 of the five-year average; each is slightly lower, but close, so the word EVEN is written into the down box.  EVEN describes the trend in pretax profit margin and ROE.   If the recent number was 19.3 or higher for pretax profit margin and 16.5 or greater for ROE, the trends would have been UP.Interpreting Section 2 of the SSGWhat you’re looking for in both the PTP margin and ROE is a trend that’s either level or increasing.  As we’ll see in the next section—Breaking up the ROE—the ROE and pretax profit margin should track.  If the pretax profit margin shows a decline, that’s a red flag.  This decrease often means the advent of an aggressive competitor.  The PTP trend in K-Mart started to show problems as Wal-Mart expanded.  Well managed companies tend to be able to better adapt to their environment than do their competitors.  This ability normally manifests itself in a well-behaved section 2 of the SSG.Section 1 and 2 of the SSG togetherSection 1 and 2 of the SSG come together to indicate the hallmarks of a good company.  As we’ll talk about later, there is often one or maybe two companies in a given industry that stand out as a leader.  The leader often has the following traits:1.    steady growth in sales and a better growth rate than competitors;2.    steady growth in earnings and better than competitors;3.    a steady or slightly increasing pretax profit margin; once again, this margin is better than competitors;4.    a steady or slightly increasing ROE—guess what, the ROE is better than competitors; the company does not need to borrow too much;5.    the leading company usually has a lower debit to equity ratio—being the leader, it finds it easy to capitalize operations through equity.Ellis Traub, NAIC guru and creator of the Investors Toolkit, and all around great guy, describes the ideal company as suffering from “monotonous repetition.”  No truer words were ever spoken.Preferred Procedure for Calculating EPSIn the last section, we determined the future (projected) EPS growth rate from applying judgement to the growth rate observed in the past.  This approach can work well if earnings are “well behaved”: if they mirror the pattern observed in sales, but very often this situation does not prevail.Steady growth in sales is my definition for a growth company.  Some growth companies have major expenses that tend to be cyclic; cyclic expenses—expenses that follow the business cycle—often leads to cyclic or erratic earnings.  If historical earnings do not appear to be as predictable it might be good to consider the preferred procedure.The preferred procedure has as its major premise that sales may be more easily forecast compared to earnings.  The starting point for the preferred procedure are the revenues for the current year.  Clayton Homes will be used in this example.  The steps in the preferred procedure are1.    Find revenues for the most recently reported fiscal year2.    Project the estimated future sales growth for the 5 years3.    Determine the future pretax profit margin for year 54.    Determine the future tax rate for year 55.    Determine preferred dividends for year 56.    Determine the future number of shares outstanding in year 5These steps seem daunting, but they’re really not that difficult.We have the current revenues and we have estimated sales growth for the future—that estimate was taken as 15% per year.  This estimate was made in the first chapter.  Here is the calculation for revenues in 2004.1999    $1344.302000    $1344.30 x 1.15 = $1545.952001    $1545.95 x 1.15 = $1777.842002    $1777.84 x 1.15 = $2044.512003    $2044.51 x 1.15 = $2351.192004    $2351.19 x 1.15 = $2703.87To calculate projected revenues for fiscal year 2000 (which ended in June 2000), you take revenues for fiscal year 1999 and increase them by 15%.  Multiplying fiscal year 1999 earnings by 1.15 is the way to increase them by 15%.  Remember, when using percentages in math, they are converted into decimals by dividing by 100; so, 15% is 0.15.  Revenues in 2004 are projected to be $2703.9 million or approximately $2.7 billion.  Step 2 is now completed.We’re now going to determine the pretax profit margin.  If there is no clear trend in the pretax profit margin for the past five years, we could take the average reported towards the end of row 2A.  If there were a trend, we could use a weighted average.  When using a weighted average, you can put more emphasis on recent information compared to older data.  For the pretax profit margin we will use the past five-year average; however, I just want to illustrate how to use the weighted average.     1 x 17.9 = 17.9         2 x 18.6 = 37.2         3 x 18.9 = 56.7         4 x 19.7 = 78.8         5 x 18.3 = 91.5         15       282.1     You get the total the figures on the right hand side.  The total is 282.1.  Here’s what you’re doing: you’re going to calculate the average of 18.3 counted five times, 19.7 calculated 4 times, and so on.  You’re calculating the average of 5+4+3+2+1 or 15 numbers.  So you divide the sum of the numbers on the right hand side (282.1) by 15 (the total number of numbers) to give 18.81.  Note, the weighted average gives 18.8 while the “traditional average” is 18.7.  We’ll talk more about weighted averages when we cover section 3 of the SSG.So, we have decided to use the figure of 18.7 as the pretax profit margin for 2004.  The pretax profit margin tells us what percentage of each dollar in revenues the company gets to keep.  We have projected revenues of $2703.9 million in 2004.  If the pretax profit margin is 18.7%, the multiplying $2703.9 by 0.187 gives use the required number2703.9 x 0.187 = 505.63The company will have to pay taxes on that profit of $505.63 million.  Take a look at the Value Line survey for Clayton Homes.  The income tax rate is reported for ten years.  Clayton Homes has a pretty stable tax rate, around 37 or 38% for the past few years.  Judgement has to be applied if the tax rate is not stable.  If the rate doesn’t fluctuate a lot, you could take the average for the past few years.  If the tax rate plummets or rises sharply for one year, you could ignore that year and take the average of four or five years.  Alternatively, and this method is probably the best of all, go to the far right hand side where Value Line has a projected tax rate.  Remember that Value Line has projected items in an italicized font.  If you look at the Value Line survey for Clayton Homes, the projected tax rate is 38.0%.If the tax rate is 38%, it means that Uncle Sam gets to keep 38¢ of every dollar the company takes in.  The company gets to keep100% - 38% = 62%of the pretax profit or $505.63 x 0.62 = $313.49Clayton Homes does not have any preferred dividends.  If they did, you would subtract them from the net income of $313.49.  If the regular dividends grow over time, make an estimate of the growth rate.  Project preferred dividends by that same growth rate for five years and subtract that number from net income.Finally, we’re trying to calculate EPS—we have to figure out the “S” —the number of shares.  Value Line provides ten (10) years of information on shares outstanding.  You determine the future using a similar approach to projecting the tax rate.  Of course, the number of shares is not likely to surge or collapse suddenly, unless a spin-off, merger or acquisition occurs.  Value Line gives an estimate of the future number of shares outstanding—look over to the far right-hand side.  This number is 131 million.  You calculate EPS by dividing the net income by the number of shares outstanding.                                               This number is higher than Value Line’s estimate of $1.80—big deal!  The projected value of $2.39 implies an EPS annual growth rate of around 17.5%.Breaking up the ROEThe return on equity, ROE, is defined as net income divided by shareholders equity.  It can be broken up into a number of components—three in the example that follows.  Before we start on breaking up the ROE, a review.1. If you multiply any number by one, you get that number back.So, three multiplied by one gives three; a thousand multiplied by one gives a thousand and so on.2. If you divide any number into itself (zero doesn’t count), you get the number 1.So five divided into five gives one, a hundred into a hundred gives one, a gazillion into a gazillion gives one!  These two concepts together will now be used to crack open the ROE.  Here we go:Equation 7If you examine the equation above, assets divided into assets gives one—the equation is ROE in a slightly different form—ROE multiplied by the number 1.  You can rearrange this equation as followsEquation 8Things have just been combined here.  The next step is to multiply the equation above by one—in disguised form!Equation 9Once again, we’ve must multiplied the preceding equation by one.  Consolidating everything into a signal quotient gives Equation 10This expression is then split up into the product of three quotients.Equation 11If you’re not convinced about what just happened, you could substitute numbers for net income, sales, assets and equity; in that way, you could convince yourself that the two equations above are equivalent.The expression above divides ROE into three components or drivers.  The first is a measure of profitability, the second a measure of efficiency and the third a measure of leverage—all to be discussed!  I just want to tweak the expression a little.  To save space, I am going to abbreviate pretax profit as PTP and just use equity instead of shareholders or owners equity.  Finally the word tax is used for the tax rate—expressed as a decimal and not a percentage!  I made these changes to shorten the expressions in the equations; otherwise, they’d start to span two lines!Equation 12That’s it for deriving expressions for now.  We’ve still got three drivers, but now net income has been split up as pretax profit times one minus the tax rate.  If you go back to the start of this section to where the issue of getting pretax profit information from what’s provided by Value Line, you’ll see where this expression came from.You will notice that pretax profit over sales is simply section 2A of the SSG; ROE is section 2B.  When ROE is broken up as in the equation above, section 2A of the SSG is contained with part 2B.  Look above, pretax profit divided by sales is a part of the equation above.  In the discussion earlier in the chapter, one of the things that was stressed is that both section 2A and section 2B of the SSG are industry specific.  Well, if I didn’t mention it, they are.  In other words, you don’t find the same range of pretax profit margins in the pharmaceutical industry compared to the supermarket industry.Let’s look at the three drivers.  The first (pretax profit on sales) can be found all over the map.  For industries that are profitable, it can range from a fraction of 1% to 20%.  This first driver is a measure of profitability.The second driver, sales over assets, is a measure of efficiency.  As this ratio gets larger, it means that the industry is extracting more sales from assets.The final driver is a measure of leverage.  We know that one of the fundamental equations in accounting is that assets equals liabilities plus owners equity (capital).  This relationship in inviolate.  Think this through.  If the company has no debt—none at all—then it is 100% capitalized through equity.  That means that shareholders equity must be identical to assets.  The ratio of the value of the assets divided by that of equity will be one.  If a company has debt, the value of the shareholders equity must be a smaller value than the assets.  The ratio of the total value of the assets over equity will be greater than one.  If a company is capitalized almost exclusively by debt (liabilities), then the asset/equity ratio could be a huge number: equity will be a number that’s much smaller than that of the value for the assets.  A big number divided by a small number produces a big number!As mentioned earlier, all three drivers are industry specific; examples of these drivers are provided in the table above.  Let me make some comments about this table.  First of all, the ticker symbols in the second column are examples of companies in the particular industry; they are not investment choices or advice.  You notice that some lines are blank.  The lines are blank because the average profit margin for that industry is negative.  What’s interesting is that some of the most successful companies in the country are found in those industries.  Perhaps, Dell, Microsoft and Cisco are so dominant in their respective industries that others find it hard to make a profit!The figures in the table seem to be all over the map.  The biggest range is seen in the measure of efficiency (second driver) which ranges from 0.1 to 2.5.  Leverage (the third driver) ranges from 1.43 to 8.71.  Profit margins (net profit not pretax) are all over the board too, with restaurants just keeping their heads above water while regional banks, real estate operations and pharmaceutical companies keeping more of the dollars they bring in.Financial companies show their unique personalities.  Banks, insurance companies and brokerage services have seemingly low efficiency and high leverage.  Analysis of financial companies using NAIC principles can be found on the NAIC web site.  However, keep in mind that when such a company takes a dollar in, it has to give it (or a fraction of it) back.  If generates income by giving loans.  Banks like loans (they are assets); deposits are liabilities—they’ve done nothing to earn them and they might have to pay interest to keep them!  So, when banks take deposits, they record them as a liability.  The situation is similar for brokerage and insurance companies.Industries where competition is fierce (air courier service, restaurants, retail grocers trucking and non-alcoholic beverages) have a relatively small profit margin.  Retailers tend to be more efficient—have a higher sales to assets ratio.  With the exception of grocery stores, they also tend to be less leveraged.  The ROE of the economy overall tends to settle around 11 to 13%.Included is a figure which shows the change in ROE over time.  Companies are grouped according to the ROE in the early 1980’s, then the change in ROE is followed over time.  You can see in the graph that companies with a high ROE tend to fall over time (on average), while companies with a low, or negative ROE tend to grow over time.  The reason for this trend is competition—either introduction or elimination of competitors!  Companies that have a high ROE tend to attract competitors—the high ROE is often due to a high profit margin.  Industries where there is a negative ROE tend to have companies that go out of business.  The negative ROE is more often than not due to a negative profit margin.  As competitors go out of business, pricing competition disappears.  Those companies that survive tend to be profitable and have a growing ROE.Here’s the final kicker.  Guess what is the biggest driver for ROE?  When you examine different industries, you discover that there is usually a comfortable level of debt.  Push it too high and you can’t extract value from the assets you fund with debt.  Don’t have enough debt and you discover that you’re competitors do better.  Likewise, when it comes to efficiency, it’s often driven by technology.  Once again, there is an upper limit to asset utilization in most industries.  The thing over which companies seem to have the most control are (a) efforts to drive revenues and (b) efforts to control expenses.  Time and time again, the biggest driver for ROE is pretax profit on revenues.  The great thing about section 2 of the SSG is that the pretax profit margin is already broken out for you!ROE and R&DI’ll show the impacting of expensing rather than capitalizing R&D through use of a fictitious example.  This example shouldn’t be taken too seriously.  It’s meant to illustrate a point and not the intricacies of accounting rules!AquaPharm and Terraceutical are two pharmaceutical companies working on CureAll Hydrochloride (CAH).  CAH is a complex molecule, discovered in 1990 in a plant native to Brazil.  Both companies bought large plantations to harvest this exotic plant.  Each of the companies conducted clinical trials and received marketing approval from the FDA in ‘94.  In 1995, a fungus wiped out the worldwide supply of these plants; by late 1995 there was no supply of CAH.Terraceutical responded to this catastrophe by funding a major, in-house R&D effort to come up with an alternate way to synthesize and manufacture CAH.  The company borrowed $1 billion to support the discovery and scale-up of a new synthetic route.  Once discovered, a contract manufacturer produced the material.  AquaPharm had a completely different approach.  They discovered that microbes living deep in the ocean around geothermal vents also produced CAH.  AquaPharm borrowed $1 billion to modify and build a sophisticated oilrig-like structure (Oceanic Extractor!) that extracted, concentrated and purified the almost limitless supply of CAH.  Each company successfully passed all regulatory hurdles and received marketing approval from the FDA on January 3, 1999.  Because of the importance of this drug and the prior hardship endured by both companies, Congress enacted a bill (signed by the President) that each company would have an income tax rate of 0% from 1999 through 2004, provided that savings were passed along to consumers.  Both companies agreed (saving me a lot of extra calculations J).  CureAll Hydrochloride was stunningly successfully, garnering each company a half billion dollars in sales in the first year alone.  Here’s a look at the income statement from AquaPharm and Terraceutical, which just became available.   Income Statement Item   AquaPharm   Terraceutical   (in millions)               Revenues           Sales   $750.00   $750.00       Expenses           Cost of Goods Sold   $150.00   $150.00   SG&A   $100.00   $100.00   Depreciation Expense   $100.00   $50.00   Interest Income   $100.00   $100.00   Tax Expense   $0.00   $0.00   Net Income   $300.00   $350.00  Note, AquaPharm has an extra $50 million in depreciation because of the Oceanic Extractor built to harvest CAH from the ocean depths.  Each company borrowed $1 billion and is incurring a similar interest expense as a result.Each company has $3 billion in debt and $5 billion in existing assets; however, AquaPharm has the Oceanic Extractor, which shows up as an asset worth $950 million on its balance sheet.  Here’s a look at the two balance sheets. Balance Sheets (in billions) AquaPharm   Terraceutical   Assets   Liability & Equity       Assets   Liability & Equity     $5.95 billion       $5 billion             $3 billion       $3 billion         $2.95 billion       $2 billion     $5.95 billion   $5.95 billion   $5 billion   $5 billion                                The ROE of each company differs.  AquaPharm has an ROE of 10.2% while Terraceutical has and ROE of 17.5%—over two thirds more than AquaPharm.  Companies with a lot of R&D expense (10 to 20% of sales for pharmaceutical companies) tend to have a high ROE.  This phenomenon is caused by how R&D is treated—as an expense.  Companies with hard assets depreciate over time; R&D—in reality an asset—is recognized immediately and consequently does not appear on the balance sheet. < Prev   Next >