A look at how to properly use ROE and ROA to Measure Management Effectiveness. Learn how to interpret the numbers and see what the numbers tell you.
The tricky part with fundamental analysis is that not everything is fundamental.
There is a lot of qualitative analysis involved in fundamental analysis.
Michael Mauboussin Tips From Great Investors [Pt.2]
This is the second part of a short series on Michael J. Mauboussin's research document reflecting on 30 years of Wall Street analysis published in 2016. Q3 2020 hedge fund letters, conferences and more The document outlined Mauboussin's observations of successful investors throughout his three decades on the Street. This article starts at point six. Read More
It trips over many people, myself included.
A classic catch 22.
For example, the reason why I bought into value traps in the past is because I only looked at the quantitative side.
Had I dug deeper into the qualitative aspect of the business, it would have revealed additional clues for me to keep my money in my pocket.
My inputs and assumptions when performing intrinsic value calculations would have produced different outcomes.
It’s why books like Financial Shenanigans and my favorite, Quality of Earnings, exist.
Another aspect of financial analysis that separates the rookies with the experienced is the interpretation of numbers.
The financial statements you and I get are the same, but we could interpret it completely different.
It’s the same with management.
With the same set of numbers, management can frame and present it in a way that is different to how you see it.
How to Measure Management Effectiveness
Since I don’t trust or believe 100% of what managers say, I use data to tell me the story.
Unless the numbers are completely cooked, a management team can bluff for a year or so. But over the long run, the truth behind the numbers always prevail.
Wit that, here are ways you can read into management using ROA and ROE.
Return on Assets (ROA) to Quantify Management Effectiveness
ROA = Net Income / Total Assets
ROA looks closely at how efficiently the business is using shareholder assets to earn returns.
If you own a carpet cleaning business you’re looking at things like
- how much revenue you can make off each truck
- how many carpets your vacuum can clean on a daily basis and whether there is a way to maximize the performance
- whether you can expand into the window cleaning business with the assets you have
But ROA ignores the capital structure (debt vs equity) of a business so a single ROA value doesn’t hold much value.
You need to compare ROA over a period of time (5 or 10 years) and compare it with competitors within the same industry.
Since ROA varies significantly from industry to industry, keep it within direct competition.
ROA can also be re-written as
ROA = Net Profit Margin x Total Asset Turnover
ROA = (Net Income/Revenue) x (Revenue/Total Assets)
The above formula is the Three Step DuPont Model without the equity multiplier.
When you break it down like this, you can then determine which area of the business management is focusing on to maximize returns.
- Are they increasing prices?
- Are they cutting costs?
- Are they turning over more assets?
These are the types of questions you can answer. With this hard data and evidence, you can then compare with what management is saying and measure their true effectiveness outside of just looking at the returns from the assets.
Return on Equity (ROE) to Measure Management Effectiveness
ROE = Net Income / Shareholders Equity
This is a basic test to see how management uses shareholders money.
Obviously, a low number is not desirable.
But you can get more information about management than whether they are earning a good rate of return off shareholder money.
A rule of thumb that I’ve come across is that people tend to want 15% as the hurdle for ROE.
Since ROE is offered in all free screeners, like the Google screener, this number is overused and not utilized properly.
Like ROA, it shouldn’t just be used and compared on its own.
You need break it down and look at it over multiple rolling periods to see how the business performs during different cycles.
Consistency and sustainability over long periods of time is important.
Here are a few things to know about ROE and what it tells you about management.
- A company can’t grow earnings faster than it’s ROE unless it raises cash via debt or selling shares.
- Raising funds has a cost; debt payments of shrinking EPS if shares are sold
- ROE is a “speed limit” for a company’s growth rate
Missing in all this is the fact that ROE doesn’t care about debt.
Two stocks can have the same ROE, but have 180 degree different debt levels.
If you just look at ROE on its own and don’t interpret it correctly, it can lead you to think a stock is more profitable over another when it isn’t.
But there is a way.
Breaking down ROE using the DuPont Model will let you see deeper into the number and identify which component of the business is really doing well.
You can get answers to questions like
- whether ROE is driven by management working to improve margins
- whether ROE is affected by assets being utilized efficiently
- whether management is using debt to increase ROE returns
- whether taxes are playing an effect on ROE
By using ROE to it’s fullest potential, it provides a wealth of insight into management behavior.
To make life easier, follow the full tutorial for the DuPont model and download the spreadsheet too.
Old School Value premium members are able to perform the DuPont analysis automatically for each stock they look at.
Saves you time and it can help you save yourself from a value trap by clearly showing how management is running the business.
You can start today by being a member of Old School Value.