It's time to wrap up our special weekly series that has looked at some of the key principles behind the Hidden Gems investing philosophy.
So far, we've covered the advantages of buying smaller companies, why high levels of insider ownership are beneficial, the importance of free cash flow and structural free cash flow, how dilution harms shareholders, and the benefits of focus.
Today, we'll delve into one of the most valuable measures of management effectiveness: return on equity.
In his book The Warren Buffett Way, Robert Hagstrom Jr. wrote, "The most important management act is the allocation of the company's capital... [A]llocation of capital, over time, determines shareholder value. Deciding what to do with the company's earnings -- reinvest in the business or return money to shareholders -- is, in Buffett's mind, an exercise in logic and rationality."
Components of ROE
Return on equity, or ROE, helps us determine how well management creates value for shareholders. The formula uses just two numbers: net profit and shareholders' equity.
The first is self-explanatory. Also called net income, it's the amount of money a company earns (at least by traditional accounting standards) in a given period. The second, shareholders' equity, is the difference between total assets and total liabilities. Also known as net worth, it represents the value of the business to its shareholder owners after all obligations are paid off.
ROE shows us how much money a business earns in relation to its shareholders' interest in the company. The formula is simple:
ROE = net profit / avg. shareholder's equity
What we're doing is taking a year's worth of earnings and dividing them by the average shareholder's equity for that year. The first number is easy to come up with, the second is just a tad more complicated. Let's try an example using Middleby (Nasdaq: MIDD ) , one of Tom's Hidden Gems selections.
Looking at the income statement in the latest 10-K filing, the maker of ovens and food heating equipment took in $18.7 million in net income for all of 2003. So that's the numerator in our formula.
Moving to the balance sheet, we see shareholder equity at the end of 2003 was $62.09 million. But the number we want is the average amount of shareholders' equity during the year. In order to get that, we'll need shareholders' equity at the end of 2002, which was $44.62 million. When we calculate the average of these two numbers, we get our denominator: $44.62 million + $62.09 million / 2 = $53.31 million.
So, Middleby's ROE for 2003 was 18.7 / 53.31 = 0.35, or 35%.
For ROE, higher is better. It makes sense; we'd like to see the numerator -- net income -- growing in relation to the shareholders' interest in the company. Getting back to Buffett's "most important management act," the higher the number, the better management has allocated capital.
It's really interesting (to me, anyway) to look at the underlying levers that drive ROE. It boils down to three key tools that management has at its disposal to affect the returns of the business: pricing, asset management, and financial leverage. ROE, then, becomes a measure not simply of how much of a return the company is generating off the equity it has created, but also of how successfully management has been in running the corporation.
If you're interested in learning more about this, check out our special Return on Equity section, as well as Bill Mann's recent Selecting Stocks Using ROE.
Tough row to ROE
What makes for a good ROE ratio depends on the type of business. The beverage industry (both alcoholic and non-alcoholic) currently averages 12%-15%. That makes Coke (NYSE: KO ) and Pepsi's (NYSE: PEP ) 33% figure look pretty darned good, and Anheuser-Busch's (NYSE: BUD ) 72% downright monstrous. Dell (Nasdaq: DELL ) , at 47%, is a similar standout in the computer hardware industry, which is having trouble even achieving a positive number on average.
When mining for gem-dandies, we like to find companies that show an increasing ROE over time. It's a sign to us that management is getting better and better at deciding what to do with its money.
Middleby's ROE over the past five years looks like this:
That is a beautifully accelerating curve. What happened to cause such a turnaround? In 1998, new CEO Selim Bassoul radically restructured the business. Rejecting the idea of serving the entire kitchen, he abandoned coolers and refrigerated deli cases -- and with them more than $20 million in annual sales. Bassoul decided instead to concentrate on what the company did best: supply high-volume ovens to pizza chains and restaurants such as Papa John's (Nasdaq: PZZA ) and McDonald's (NYSE: MCD ) .
Through 2001, revenue declined 30%, but then turned and began to grow again. The profit margin began increasing. Tom recommended the stock to Hidden Gems subscribers in November 2003, and has seen it nearly triple in value since.
That's a wrap
If you've read through the other parts of this series, you now have a basic idea of some of the processes Tom Gardner goes through when valuing small-cap companies. The philosophy has been very successful so far in Hidden Gems' young life span, producing a 45% average return in 10 months, compared to the S&P 500's 3% gain.
The learning won't stop here, however. We'll keep our Hidden Gems corner open for business, and journey together each Wednesday toward our goal of becoming experts in small-cap investing.
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Rex Moore helps Tom Gardner dig for gems each month. At time of publication, he owned shares of Anheuser-Busch and was conducting extensive product testing for the company. The Fool has a disclosure policy.