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April 20, 1999

Better than ROE

By Dale Wettlaufer (TMF Ralegh)

Return on invested capital is sort of like return on equity (ROE), but greatly improves upon it. Return on equity (net income divided by average shareholders' equity in use over the period being looked at) takes into account in the denominator only the net assets in use by the corporation. A major problem with this is that certain liabilities mandated by GAAP (Generally Accepted Accounting Principles) reduce the amount of resources at the company's disposal in the ROE equation. Depending on the circumstances, though, these liabilities should not be counted as a reduction in the capital working for the benefit of shareholders. They should be counted as an addition to capital in use by shareholders. That being the case, moving an amount out of liabilities and into owners' equity necessarily increases the denominator of the ROE equation and thus lowers the company's return on equity.

For example, insurance underwriter Cincinnati Financial (Nasdaq: CINF) owns large stakes in bank holding company Fifth/Third Bancorp (Nasdaq: FITB) and telecom services concern ALLTEL Corp. (NYSE: AT), both of which are being carried on its books at market value rather than at cost. Because banks and insurance companies have to mark their investments to market (value them on the balance sheet at market value), they also have to record a liability for taxes that would have to be paid if they were to liquidate the holdings. This liability is called a "deferred liability," because payment (or realization) of the liability is deferred until realization of the gain takes place. For CinFin, the difference between the cost and market value of these investments at year-end was $2.78 billion. That means there's a deferred tax liability on the books equal to its tax rate times the amount of this unrealized appreciation in investments.

Say CinFin has no intention of selling these investments within the next ten years? The deferred tax liability might exist in the mind of the company's creditors, insurance examiners, and accountants, but in the minds of the people running the company, the value of the liability is much less than the balance sheet states it to be. The company's operating managers can make investments and operating decisions based on a net value of these assets that is much larger than the balance sheet indicates. The amount of capital at the disposal of operating managers is much closer to the value of the assets on the balance sheet and not the value of the net assets (the investments minus the deferred tax liability) indicated by the balance sheet. They haven't put aside $1 billion to cover this liability, so investors must charge management with a larger amount of owners' equity in assessing the company's return on owners' equity for the period.

To reflect the difference and bring the amount of owners' equity closer to the actual amount of invested capital at the company's disposal, an investor or analyst would make changes to the following balance sheet:

Investments (in 000s):

Fixed maturities, at fair value...$2,751,219

Equity securities, at fair value...$5,999,271

Other invested assets...$46,560

Total assets...$9,493,425

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Deferred income taxes...$1,406,478

Total liabilities...$4,776,460

Total shareholders' equity...$4,716,965

Total liabilities and shareholders' equity...$9,493,425

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We wouldn't make any adjustments to the asset accounts. Therefore, the sum of liabilities and owners' equity has to still match the amount of total assets. About 71% of the deferred tax liability is due to the appreciation of the Fifth/Third and Alltel stock, and these are by far the largest identifiable single equity positions the company has. So, we'll just treat these two in making adjustments.

We'll assume the company plans on holding these investments for another 10 years, and that the company can invest a sum of money in the S&P 500 and generate an 11% yearly return on that investment to cover the liability once it is realized. Based on the current gain that is on the balance sheet, it would need to set aside $382.4 million to cover the $1.086 billion liability for the unrealized appreciation of these investments on the balance sheet ($382 million invested at 11% per year for 10 years = $1.086 billion). That equals $704 million, which reduces deferred taxes and thus, total liabilities, by that amount, and is transferred to owners' equity. Therefore, the liabilities and owners' equity accounts look like this:

Deferred income taxes...$702,478

Total liabilities...4,072,460

Total shareholders' equity...5,420,965

Total liabilities and shareholders' equity...$9,493,425

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Last year, Cincinnati Financial earned $299.38 million. On the first amount of owners' equity, the company would have generated a ROE of 6.35%. On the revised amount of owners' equity, the company's ROE was 5.5%. By making these adjustments, we can tell how the company is performing with the actual amount of investable assets under the control of its operating people. Insurance companies and banks make underwriting and lending decisions based on statutory limitations involving owners' equity, so these liabilities do indeed dictate the amount of business CinFin can do. But if we make these adjustments across a group of companies we're comparing as investors, we get a better idea of how well the company is operating.

In the next section we'll work into a full definition of ROIC and how that better refines some of these looser adjustments to just owners' equity In short, not all assets are funded by owners' equity, so looking at just owners' equity as a measure against which return is compared is going to miss the boat at times. Those companies that finance their assets with just a sliver of owners' equity and a boatload of liabilities can drive the value of owners' equity to zero pretty quickly with just one misstep. A 20% return on owners' equity in a company with very low leverage (defining leverage for these purposes as the ratio of assets to owners' equity) is a much different and preferable result to a company with very high leverage generating an ROE of 20%. We need an alternative definition of capital that measures the full amount of capital in use by a company's managers, whether that capital was raised through equity or through debt. In other words, we want to look at the company's performance independent of its financing decisions. ROIC is the way to do that.

Next: An Example

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