Last week we looked at whether or not the Rule Maker's old bright line of 10% per annum sales growth made any sense. This generated some awfully interesting discussions on the Rule Maker Strategies Discussion Board, with one Fool Community member in particular taking me to task for pooh-poohing top-line growth as a measure of a company's health.
This particular Fool, badsin, echoed my thoughts quite succinctly when he stated, "It's strong relative growth that should be the criterion -- relative to competition, relative to the economy, relative to inflation. Ideally, starting with the top line all the way thru the financials."
OK, I'm not a big fan of the abbreviation "thru," but besides that, this is perfect. I think we should just incorporate these very words into our thoughts about Rule Makers. If you have a company that doesn't show much growth, but dominates an industry that is also fairly static, you could have a Rule Maker. But a company exhibiting minimal growth when its peers are gaining fast most certainly is NOT. Rather, it is dying. Think Sears (NYSE: S), Xerox (NYSE: XRX), Kmart (NYSE: KM). If Sears were building its global headquarters today, do you think it would be one of the tallest buildings in the world? Me either. A Sears tower built today MIGHT be the tallest building in Tulsa.
We're weaving a web here, in the hope that the truly outstanding companies will identify themselves. From there we can concern ourselves with investing, the other side of the coin. Our next item comes in three parts due to some serious flaws in return on equity (ROE). Still, for anyone wanting to learn about business analysis, ROE is important.
I'm going to make use of some excellent resources that exist in the Fool archives, particularly Paul Commins' two-part series entitled "You Need to Know ROA and ROE" as well as the oh-so-creatively named "Return on Equity" series from Fool's School. Rather than reinventing the wheel, I'd ask anyone who needs deeper explanations of the concept and mechanics of ROE to examine those resources.
Essentially we want to know how much shareholder equity a company needs to invest up front in order to generate its earnings. Equity, as we learned in gym class, is simply stated as the company's assets -- its liabilities on its balance sheet. What, you didn't learn about balance sheets in gym class?
One of the companies with the greatest ability to generate wealth over the last 10 years has been Microsoft (Nasdaq: MSFT). If we take Microsoft as an example, in its last 10-K we get the following results:
(in millions) Total Assets: $59,257 Total Liabilities: $11,132 Deferred Tax: $836 Stockholders equity: $41,368 Net Income: $7,346
Return on Equity (Net Income / Stockholders' equity) = 17.7%
Let's do this with another company. How about I take another swipe at Sears?
(in millions) Total Assets: $36,899 Total Liabilities: $30,130 Stockholders equity: $6,769 Net Income: $1,343
Now, just a minute. How is it possible that Sears ended up with a higher ROE than Microsoft?
There are several reasons, and therein lies the fault of putting too much faith solely on ROE. Problem #1 is that ROE actually goes up with every added dollar of debt. Look at Microsoft's debt level versus that of Sears. Sears' earnings are less than a quarter of Microsoft's, but Sears' asset level is more than half, and its liability level is triple.
Problem #2 is the inexactitude of the numerator in this case, earnings. Earnings are an accounting construct, and as the number that most investors seem to focus on, it is the target of some pretty hefty gymnastics by many companies to make it look as good as possible.
Problem #3 is that we've simply taken a snapshot of one year. Big, big mistake, because as we have discussed before, a one-year view of a business does not tell us very much at all. If the data is available, look at generating ROE for a 10-year period.
At any rate, ROE is descriptive of a company's ability to make money. What it does not describe are the liabilities, or that new buzzword, the "quality of those earnings." But a trend of declining ROE over time can show us a company that has to use more and more capital in order to generate profits.
In order to make sure that we are balancing stable to increasing ROE with a healthy balance sheet, we're going to make this a two-step criterion. We want return on equity to equal 10% or greater in the period of study for a company, but we also want debt to be no more than 50% the size of the asset base. In many situations, companies are actually aided by taking on debt -- I actually think that a company with zero debt in most cases is being too conservative, because debt is "leverage," something that shows up both as an asset and as a liability. Some debt is a good thing. But like the old adage says: "there is such a thing as too much of a good thing." Unless we're talking about beef jerky, I agree.
Where you have a company with healthy (and possibly expanding) ROE and assets that far exceed debts, you have a company that has been able to grow through time. You may also have a Rule Maker.
Bill Mann, TMFOtter on the Fool Discussion Boards
Farewell, Josh Miner. Bill Mann owns none of the companies mentioned in this article. The Motley Fool is investors writing for other investors.