High return on equity stocks at a reasonable price?

[Liberty]

On the topic of ROIC, BaseHitInvesting has a great multi-part series on it. The latest post is here:

 

http://basehitinvesting.com/importance-of-roic-part-5-a-glance-at-the-last-42-years-of-wells-fargo/

 

But if you look back, there's at least 5 in this series, and a couple others looking at Greenblatt's approach and such.

[west]

For what it's worth, I reviewed Damodaran's online material, and he *does* use the PV of leases in the Invested Capital part of the ROIC calculation (along with a bunch of other stuff like capitalized R&D, advertising, etc.):

 

http://www.stern.nyu.edu/~adamodar/podcasts/Webcasts/ROIC.mp4

 

I still don't understand the rationale of why you would put the PV of future leases into your ROIC calculation though, so I sent him an email about it.  He hasn't responded yet, but I've had decent luck with talking with him in the past.  We'll see what happens.

[vinod1]

For what it's worth, I reviewed Damodaran's online material, and he *does* use the PV of leases in the Invested Capital part of the ROIC calculation (along with a bunch of other stuff like capitalized R&D, advertising, etc.):

 

http://www.stern.nyu.edu/~adamodar/podcasts/Webcasts/ROIC.mp4

 

I still don't understand the rationale of why you would put the PV of future leases into your ROIC calculation though, so I sent him an email about it.  He hasn't responded yet, but I've had decent luck with talking with him in the past.  We'll see what happens.

 

Taking on a lease is the same as taking on debt. Instead of buying machinery that has a life of 10 years you take on amortizing debt for a term of 10 years and they are essentially the same. You would have incurred a contractual liability.

 

Vinod

[rayfinkle]

I don't see how including debt can determine quality of business. It seems return on equity is the only measure of quality businesses. If a business earns high ROE due to debt, it's not due to the business quality but the leverage factor unless one condition is met - it can earn the same return on the debt which means incredible ability to scale up. This may be the case for the best of the best but most are just juicing the leverage factor at a much lower return than their core return.

 

Let's say there are two companies, the first one puts in $100 and generates $10 in earnings, a 10% return on capital.  The second one puts in $30 in cash and $70 in debt and makes the same $10.  You're saying that second business is 'better' because it's earning 30% on equity.  I disagree with this statement.  You need to include the full capital structure.

 

Slight tweak necessary though, right: an underlevered business is suboptimal (under-earning on equity) just as an overlevered business is suboptimal (required allocation of CF to debt service = fragility & reduced optionality).

[scorpioncapital]

Does anybody know the pros and cons of using pre-tax vs after-tax operating income to calculate return on invested capital to determine quality of the business? I've seen some exciting numbers pre-tax but when you deduct the government's 35% take, sometimes it doesn't look so hot. I.e. it may be 15-16% pre-tax but a more sedate 10% after-tax. Does it make any difference? For example, Buffett has compounded book value at 20% per year on average, I assume this is after-tax.

[west]

For what it's worth, I reviewed Damodaran's online material, and he *does* use the PV of leases in the Invested Capital part of the ROIC calculation (along with a bunch of other stuff like capitalized R&D, advertising, etc.):

 

http://www.stern.nyu.edu/~adamodar/podcasts/Webcasts/ROIC.mp4

 

I still don't understand the rationale of why you would put the PV of future leases into your ROIC calculation though, so I sent him an email about it.  He hasn't responded yet, but I've had decent luck with talking with him in the past.  We'll see what happens.

 

Taking on a lease is the same as taking on debt. Instead of buying machinery that has a life of 10 years you take on amortizing debt for a term of 10 years and they are essentially the same. You would have incurred a contractual liability.

 

I totally understand the leases as debt aspect of things.  I always use the PV of leases when calculating EV (at least when I can read about them... with my Japan companies I can't).

 

The thing I don't understand is... ROIC *should* measure the return on *invested* capital.  Not the return on *future* invested capital.  If I willingly extend a lease I'm in because I can lock in a below market rate, and I end up doing this because it will benefit me more to do so than waiting to do so will, doing that will *lower* my current ROIC.  That makes no sense!  The return on the capital I've invested should remain the same!  I haven't fronted any money yet, so my current economic returns should remain the same.  At least I think so.

 

Maybe we're confusing apples and oranges though.  In Damodaran's books, he talks about ROC (Return on Capital), *not* ROIC (Return on *Invested* Capital).  Maybe we're making the mistake of assuming they're the same thing?

 

[west]

Does anybody know the pros and cons of using pre-tax vs after-tax operating income to calculate return on invested capital to determine quality of the business? I've seen some exciting numbers pre-tax but when you deduct the government's 35% take, sometimes it doesn't look so hot. I.e. it may be 15-16% pre-tax but a more sedate 10% after-tax. Does it make any difference? For example, Buffett has compounded book value at 20% per year on average, I assume this is after-tax.

 

The only benefit to using pre-tax numbers is there's a lot less "noise".  You *have* to consider taxes though.  After all, you can't reinvest what the government takes.

 

What I like to do is use the pre-tax ROIC and then apply an assumed tax rate to it.  The tax rate I assume is primarily based on the country/state the company is in, and also based on how well the company has managed taxes in the past.  A ten year average effective tax rate will probably work, if you're looking for a simple method, but you have to be careful for one-time tax issues as well as potential changes in tax rates that happened during the period.

[cobafdek]

If I willingly extend a lease I'm in because I can lock in a below market rate, and I end up doing this because it will benefit me more to do so than waiting to do so will, doing that will *lower* my current ROIC.

 

Actually, it turns out it will not necessarily lower the ROIC.  The missing piece in this discussion is what the analyst uses as cost of capital to make the adjustments of both the numerator and denominator.  Excess Return = ROIC - Cost of Capital, and both of these variables will change when you capitalize leases, resulting in an unpredictable effect on Excess Return (and thus on discounted cash flow value of equity).  For most firms, Excess Return will decrease, but for many it will actually increase.  Damodaran himself did a study on the effect of capitalizing leases, showing many such increases.

 

http://people.stern.nyu.edu/adamodar/pdfiles/papers/newlease.pdf

 

See pages 30, 31 for the effect on discounted cash flow value.  The appendix show the results of his study.

[west]

If I willingly extend a lease I'm in because I can lock in a below market rate, and I end up doing this because it will benefit me more to do so than waiting to do so will, doing that will *lower* my current ROIC.

 

Actually, it turns out it will not necessarily lower the ROIC.  The missing piece in this discussion is what the analyst uses as cost of capital to make the adjustments of both the numerator and denominator.  Excess Return = ROIC - Cost of Capital, and both of these variables will change when you capitalize leases, resulting in an unpredictable effect on Excess Return (and thus on discounted cash flow value of equity).  For most firms, Excess Return will decrease, but for many it will actually increase.  Damodaran himself did a study on the effect of capitalizing leases, showing many such increases.

 

http://people.stern.nyu.edu/adamodar/pdfiles/papers/newlease.pdf

 

See pages 30, 31 for the effect on discounted cash flow value.  The appendix show the results of his study.

 

Many, many thanks, cobafdek!  I will definitely have to check this out.  (But not tonight!)

[Patmo]

I use a way that seems simple... I just look at ROE through a dupont analysis and adjust for leverage to find out what ROE would be with 0 debt (aka assets/equity is 1). Is there something wrong with this?

[sternalot]

(Oh, also there's ROIIC, which is Return on *Incremental* Invested Capital, which is just as important, if not (potentially) more important, than ROIC.  It measures how much return you're getting on *new* capital investments.)

 

 

1000000% agree. The trick to compounding is finding new ways to allocate capital. By determining the return on future incremental capital employed, you should get a better sense for where ROIC and also ROE, all else equal, should move in the future.

[scorpioncapital]

In this article, http://basehitinvesting.com/importance-of-roic-part-5-a-glance-at-the-last-42-years-of-wells-fargo/, he writes,

 

"A business will compound value at a rate that approximates the following product: ROIC x Reinvestment Rate."

 

He gives an example of Wells Fargo: "So as you can see: 15% ROE and 66% Reinvestment Rate = 10% Intrinsic Value (Book Value) CAGR. "

 

The question I wasn't clear though was that there appears to be an underlying assumption here, or at least a tautology which is that the reinvestment % implies reinvestment at the original rate. If this investment is not met, then ROE will fall. So this % refers back to the original number. One would have to see somehow, perhaps by separating out the extra money added and the extra income generated the new return. In a way, this seems connected with growth rate but am a bit unclear how.

 

One may also conclude that any management which pays a dividend is unsure or admitting to be unable to reinvest at the original high rate of capital. Dividend policy seems nebulous at best, sometimes it's follow the leader, sometimes it's just uncertainty.

 

 

 

[KCLarkin]

The question I wasn't clear though was that there appears to be an underlying assumption here, or at least a tautology which is that the reinvestment % implies reinvestment at the original rate. If this investment is not met, then ROE will fall. So this % refers back to the original number. One would have to see somehow, perhaps by separating out the extra money added and the extra income generated the new return. In a way, this seems connected with growth rate but am a bit unclear how.

 

It is simpler than it appears. Just watch the historical ROE. If ROE drops, there are a few possibilities:

a) Return on incremental capital is less than legacy ROE

b) Moat broken or business faltering

c) Cyclical business (in which case you need to normalize ROE)

d) Temporary issue (buying opportunity).

 

All of these are things you want to know about.