Drip
Portfolio Report
Thursday, April 23, 1998
by Dale Wettlaufter
([email protected])
ALEXANDRIA, VA (April 23, 1998) -- First, a note on yesterday's vote on whether we should keep up with just the theoretical side of things or go with a mix of theory and practical. I want to thank everyone for their mail. I believe the way we go about things here in the DRIP, where we don't just throw a pick at you and say, "Here, here's what we're buying," is the best way to go about things, and that has been borne out by the quality and intelligence of your emails. Many people were in no rush whatsoever and wanted to stay grounded in the theoretical side of things. The other side of the coin, I have concluded, is that people don't necessarily want to rush right to the picks, but their learning of the subject matter would be greatly helped by looking at the theoretical in light of the practical.
So, we're going to look at one or two companies per week from now on as well as continuing with the theoretical. We won't get that in-depth into things until the final round of narrowing down the companies for the final selection. We will, however, mix in both methods of learning, which will keep everyone engaged and allow me more flexibility in the way we look at things. Thanks to everyone for your input on this -- I really appreciate it.
Here's a balance sheet for a large regional bank for its year that just ended. Because the company had closed a large merger following the closing of the books for the fiscal year, the bank as it stood when the 10-K was released looked much different from what was published in the year-end financials. Most of the terms have been covered in the glossary, but there are some others that I'll add to the glossary later. I wanted to pass on the definitions today and concentrate on the structure of the balance sheet and some things that you should look at when analyzing the company's productivity.
A balance sheet is called that because of the accounting tautology: ASSETS MINUS LIABILITIES = OWNERS' EQUITY, or A - L = OE. If we express the equation in a different way, adding "L" to both sides, the equation would look like ASSETS = LIABILITIES + OWNERS' EQUITY, or A = L+OE. The assets on the left side of the balance sheet show resources at the company's disposal, while the right side of the balance sheet shows the origin of those resources.
When one side of the balance sheet changes, there must be an equal and offsetting change in the other side of the balance sheet. If assets increase, there must be an increase in owners' equity or liabilities, and if liabilities or owners' equity decrease, there must be a decrease in assets. However, as we have pointed out, balance sheet realities don't always reflect the true economic value of a corporation. Coca-Cola (NYSE: KO), for example, carries no asset to reflect the value of its namesake brand. By the tautology of A = L + OE, there is no reflection of the value of the Coke brand name in owners' equity.
The two very basic pools of capital or net capital that bank investors look at when they are analyzing capital efficiency are total assets and owners' equity. Return on assets (ROA) is simply net income divided by total assets, and return on equity (ROE) is net income divided by shareholders' equity. Some ground rules for looking at these measures. First, return on equity is measured by taking net income and dividing it by average owners' equity for the year. While I don't think it's correct to judge ROE by putting just beginning owners' equity in the denominator of the equation, it is still far more indicative of performance than figuring ROE based on owners' equity at the end of a given period. That is never correct, in my mind. Same thing for ROA -- use average assets in the denominator.
Also, make whatever adjustments to net income you feel are necessary. For instance, American Express (NYSE: AXP) today reported net income before and after extraordinary items, which included a gain on sale of First Data Corp. (NYSE: FDC) stock and dividend income on the preferred stock of Lehman Brothers Holdings (NYSE: LEH) as well as a charge for increasing credit loss reserves due to deteriorating credit quality in Asia. I would personally back out the gain on sales of stock and the dividend income from Lehman Brothers (if Amex doesn't plan on holding onto those shares), but I would not call a credit loss provision extraordinary. That's the breaks in the banking business. When you lend money, credit losses are a normal part of the economics of the business model. So, my look at return on equity would be colored by that analytical judgment.
Also, ROE and ROA are impacted by a company's acquisition strategy. As we discussed in our look at amortization of goodwill expense, goodwill is an asset that arises from the acquisition of one company by another. No such asset arises from a merger or an acquisition financed through a stock swap, or exchange of shares. That asset must be charged off over a number of years, as well. The earnings portion of ROA and ROE calculations are affected by the goodwill amortization expenses even though in many cases, the cost of capital associated with an acquisition is double-counted since cash acquisitions are in most cases debt-financed.
We can therefore observe the entire expense of that acquisition, and not just the expense associated with retiring the premium to book value we paid, in the interest expense that goes along with the debt used to finance the acquisition. OK, I am well aware that's a mouthful. The logical progression: In a cash-based, debt-financed acquisition, goodwill amortization expenses overstate the cost of the acquisition. That's because the interest on debt used to finance the acquisition adequately reflects the cost of doing the deal. Not only that, but goodwill arises from just the difference between appraised net asset value (somewhere in the neighborhood of shareholders' equity) and the purchase price for the company. The interest expense from debt used to finance a purchase covers the entire purchase price, which more conservatively depicts the cost of the deal.
A company could agree to acquire via a stock swap another company at a ridiculously high price. Though EPS would be impacted by a much larger share base, there would be no impact in the company's ROE and ROA, because owners' equity isn't affected by a stock swap and goodwill is not created in such a transaction. ROE and ROA aren't per-share capital efficiency ratios. So, in looking at ROE and ROA, we want to put on an equal footing all financial services companies, regardless of the way they have financed their expansion.
We thus have to adjust the numerator and the denominator in the ROE and ROA equations. We need to add back goodwill amortization expense from the earnings numerator in the ROE and ROA ratios and take out the goodwill asset for the assets or equity bases in ROA or ROE. If those aren't in the company's financial statements, the Fed makes this available for the 100-largest bank holding companies at its National Information Center website.
I've highlighted below common equity in red (subtract preferred stock from owners' equity) for the ROE calculation and total assets in green(subtract goodwill from total assets) for the ROA calculation. (AOL users please expand screen to view table.)
Year Ended December 31, 1997
Assets
Cash and cash equivalents ..........$ 10,586
Time deposits placed and other
short-term investments ................2,395
Securities
Held for investment,
at cost (market value -- $1,161).......1,156
Available for sale .................. 46,047
---------
Total securities .....................47,203
---------
Loans Held for Sale....................2,911
Federal funds sold and
securities purchased
under agreements to resell ...........10,022
Trading account assets ...............23,678
Loans and leases, net of
unearned income .....................142,718
Factored accounts receivable ..........1,074
Allowance for credit losses ..........(2,782)
--------
Loans, leases and factored
accounts receivable, net
of unearned income and allowance
for credit losses....................141,010
--------
Premises and equipment, net ...........3,225
Customers' acceptance liability .......1,154
Interest receivable ...................1,721
Mortgage servicing rights .............1,282
Goodwill ..............................8,625
Core deposit and other intangibles ......755
Other assets ..........................9,995
--------
$264,562
=======
Liabilities
Deposits
Noninterest-bearing ................$ 34,674
Savings ...............................9,385
NOW and money market
deposit accounts......................40,611
Time .................................39,131
Foreign time .........................14,393
--------
Total deposits ......................138,194
--------
Federal funds purchased
and securities
sold under agreements
to repurchase ........................43,882
Trading account liabilities ..........15,207
Commercial paper ......................2,796
Other short-term borrowings ...........4,126
Liability to factoring clients ..........591
Acceptances outstanding ...............1,154
Accrued expenses and
other liabilities .....................8,116
Trust preferred securities ............1,955
Long-term debt .......................27,204
--------
Total liabilities .................. 243,225
--------
Contingent liabilities and other financial commitments
Shareholders' Equity
Preferred stock: authorized -- 45,000,000 shares;
issued 2,201,728 shar.....................94
Common stock: authorized -- 1,250,000,000 shares;
issued -- 712,188,008 shares...........9,168
Retained earnings ....................11,754
Other, including loan to ESOP trust .....321
--------
Total shareholders' equity ...........21,337
--------
$264,562
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