ALEXANDRIA, VA (April 27, 1998) -- Last Thursday, we talked about return on equity and return on assets. These are, as you may recall, two of the primary measures of capital efficiency for a financial services company. ROE encapsulates more than just net income divided by average shareholders' equity. It encapsulates leverage, asset turnover, and profit margins. For instance, let's look at why American Express (NYSE: AXP) generates such a great ROE despite its below-average margins in its industry.
The Amex ROE Conundrum
Many financial services companies take a lot of capital to generate earnings. Debt-to-equity is one way to look at leverage, but a more reliable indicator in the financial services industry is looking at a company's average assets-to-average equity ratio. American Express's average assets-to-average equity ratio of 12.62 is below the industry average of 14.84, using a universe of 15 companies including Citicorp, Chase Manhattan, and Merrill Lynch as "the industry."
Taking Merrill Lynch out of that universe shows that Amex is still below the industry average leverage ratio of 13.53. Leverage can also be expressed as the ratio of average equity to average assets. Divide the first leverage ratio by one. As Pascal said: "Divide by one. Always divide by one." It's true -- the reciprocal says a lot about things. 1 divided by Amex's leverage ratio of 12.62 = 0.0792. So, the company has 7.92 cents in equity for each dollar in assets it uses versus 7.39 for the industry without Merrill Lynch in there and 6.74 with Merrill Lynch included. Amex's isn't light on capital but it's not as heavy as the rest of the industry any way you look at it. In the first leverage ratio, the higher the number, the more leverage, and in the second, the lower the number, the more leveraged the company is.
What mitigates the heavy leverage employed are two other ratios an investor should pay attention to: Asset turnover and net margin. Asset turnover measures how many times per year a dollar of assets can generate a dollar of revenues. For the financial services industry, this ratio is quite low, at 6.7%. Looking at the inverse of that number, 6.58% divided by 1.0 = 15.2. That means it takes 15.2 years for a dollar of assets to turn into a dollar of revenues. In the inverse, the yield of revenues to assets is 6.58%. Ow. Compared to that average, American Express does very well for itself with an asset turnover ratio of 14.74%. That means it takes 6.78 years for a dollar of assets to turn into a dollar of revenues. At less than half the time it takes competitors to turn over assets, Amex more than makes up for its below-average net margin.
With net margin of 11.83%, the company lags the rest of the industry by a considerable amount. Long-term investors are looking at this part of the financial model for improvement. If Amex can keep up its faster pace of product development and ability to add unique value to its products, net margin will increase and bring about not only an explosion in net income, but possibly higher valuation multiples.
These metrics taken together form our basis for looking at a financial services company's financial model:
LEVERAGE x ASSET TURNOVER x NET MARGIN = Return on Owners' Equity, or ROE.
In the case of Amex, this elements of the algorithm look like this:
Leverage = 12.62
Asset turnover = 14.74%
Net margin = 11.83%
Multiplying the three produces return on equity of 22%. The end result is Amex's return on equity far surpasses the industry average of 17.55% with less leverage and lower margins. The secret is the fast turnover of assets and intelligent use of leverage.
We've talked about it before, but we're going back to it. Accounting for past acquisitions can have a profound impact on the way we judge a company's capital efficiency. Wells Fargo (NYSE: WFC), a low-cost California bank that some consider to be extremely high quality, shows a wide divergence in the way we should look at ROE and the way the standard ROE model is constructed.
Its net income divided by owners' equity results in ROE of 8.4% for 1997. That would put the company far below the industry average 17.55% level. However, we know that Wells Fargo is generating lots of non-cash goodwill amortization expenses from its acquisition of First Interstate. The amortization schedule, or number of years over which it has chosen to charge off the goodwill, plays a large part in the company's income statement. But if they charged if off over five years or forty years, it would still have no effect on cash flow. So, we scrub out amortization expenses from earnings to get to what I rather dully call "ROE2." This wipes out the difference in amortization schedules between banks and gives us more of an apples-to-apples comparison between companies.
Of course, amortization schedules make a huge difference on the owners' equity side of things. So, to totally wipe out the effects of past cash-based acquisitions, we have to take goodwill out of owners' equity.
So, whereas ROE = NET INCOME DIVIDED BY AVERAGE OWNERS' EQUITY,
And ROE2 = (NET INCOME + GOODWILL AMORTIZATION) DIVIDED BY AVERAGE OWNERS' EQUITY,
Amortization Adjusted ROE = (NET INCOME + GOODWILL AMORTIZATION) / (((BEGINNING OWNERS' EQUITY MINUS BEGINNING GOODWILL) + (ENDING OWNERS' EQUITY MINUS ENDING GOODWILL)) / 2).
For Wells Fargo, the differences boil down to this:
ROE = 8.37%
ROE2 = 10.78%
Amortization Adjusted ROE = 23.02%
Tomorrow: A re-cap of who we'll be looking at.