How Your Money Builds A Business
Smart business owners commit their capital only to projects that promise to sweeten their bottom lines. Smart shareholders can do the same, by buying only into companies that use their equity efficiently in order to grow earnings.
The measure of how effectively a company deploys its shareholders' money is its return on equity (ROE). Return on Equity = net income divided by shareholder equity, and it reflects the success of management decisions about issues like pricing strategies, asset purchases, and capital structure.
The art of this investing approach lies in selecting the companies that will continue or increase their efficient use of shareholders' equity. And your homework as an investor involves getting convictions that the companies you have selected can sustain those numbers.
But how do you know that they can? One way is to look at the numbers behind the numbers. For an idea of where a company's ROE growth is coming from, analysts often factor that ratio (net income/equity) as the product of three other ratios: profit margin (net income/sales) x asset turnover (sales/assets) x financial leverage (assets/equity). This works both mathematically and financially, tying ROE not just to a company's net income and equity but also to other elements of its balance sheet (assets), and income statement (sales).
Profit margin is the percent of each dollar of sales the company actually ends up with. The more money it can get for its products relative to the cost of making them, the higher its margin will be and the better its prospects of continued growth. However, product pricing depends on how much competition the company faces in its market segment now and in the future.
A firm's asset turnover indicates how efficiently it uses its assets. As with profit margin, higher is better. But you have to look at a company's ratio relative to its industry norm, since businesses that require more capital investment will generally generate lower turnovers. Financial leverage tells you how much debt a company has on its books. Keep it low. Some debt can fuel growth; too much may stunt it in tough times.
With all these ratios, focus on trends rather than on the most recent figures, and dig for explanations beyond the financial statements. Accepted accounting principles allow great leeway in reporting the numbers, and the rules are subject to change, which affects consistency. Mergers and write-offs can also throw a monkey wrench into your analysis.
To interpret the figures you find, study the people responsible for them. Read management's discussion and analysis in the annual report, and go back a couple of years to check for consistent focus, because some managements seems to crank out a new set of goals each year.
Those companies that have used equity well in the past, despite industry changes and business cycles, have good odds for continued success in the future!
* * * * *
The measure of how effectively a company deploys its shareholders' money is its return on equity (ROE). Return on Equity = net income divided by shareholder equity, and it reflects the success of management decisions about issues like pricing strategies, asset purchases, and capital structure.
The art of this investing approach lies in selecting the companies that will continue or increase their efficient use of shareholders' equity. And your homework as an investor involves getting convictions that the companies you have selected can sustain those numbers.
But how do you know that they can? One way is to look at the numbers behind the numbers. For an idea of where a company's ROE growth is coming from, analysts often factor that ratio (net income/equity) as the product of three other ratios: profit margin (net income/sales) x asset turnover (sales/assets) x financial leverage (assets/equity). This works both mathematically and financially, tying ROE not just to a company's net income and equity but also to other elements of its balance sheet (assets), and income statement (sales).
Profit margin is the percent of each dollar of sales the company actually ends up with. The more money it can get for its products relative to the cost of making them, the higher its margin will be and the better its prospects of continued growth. However, product pricing depends on how much competition the company faces in its market segment now and in the future.
A firm's asset turnover indicates how efficiently it uses its assets. As with profit margin, higher is better. But you have to look at a company's ratio relative to its industry norm, since businesses that require more capital investment will generally generate lower turnovers. Financial leverage tells you how much debt a company has on its books. Keep it low. Some debt can fuel growth; too much may stunt it in tough times.
With all these ratios, focus on trends rather than on the most recent figures, and dig for explanations beyond the financial statements. Accepted accounting principles allow great leeway in reporting the numbers, and the rules are subject to change, which affects consistency. Mergers and write-offs can also throw a monkey wrench into your analysis.
To interpret the figures you find, study the people responsible for them. Read management's discussion and analysis in the annual report, and go back a couple of years to check for consistent focus, because some managements seems to crank out a new set of goals each year.
Those companies that have used equity well in the past, despite industry changes and business cycles, have good odds for continued success in the future!
* * * * *
posted by Bob Moser at
5:43 PM
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