Distractions, distractions, distractions. Whenever we go to analyze stocks for our portfolio, there are loads of news articles, analyst calls, and earnings estimates that distract us from our true goal: determining how to earn a return on investment. When we can avoid the distractions, identify great companies, and let compounded interest take care of the rest, it's a magical thing.
One way to filter out the noise is to simply look at a company's return on equity. It is quite possibly the most bare-bones way to see how much return you can expect per dollar invested in the company. Let's see how this metric works in comparing two major oil and gas equipment and services companies: National Oilwell Varco and Baker Hughes.
By the numbers
Return on equity is simply a company's earnings from continuing operations divided by its total shareholder equity. Looking at the returns for these companies over the past five years, National Oilwell Varco has held a steady, comfortable advantage over Baker Hughes.
This hasn't always been the case. Prior to the financial collapse in 2008, Baker Hughes generated much more impressive returns that absolutely demolished NOV. During the years of extremely high oil prices (2005-2007), Baker Hughes pulled in annual returns on equity in excess of 25% and in one year beat National Oilwell Varco by more than 30 percentage points!
While these historical numbers are helpful, return on equity from net income is a pretty crude way of calculating a return. After all, management can boost returns on equity by issuing debt, which doesn't necessarily mean the company is more profitable. For a better understanding of those returns, we can break down ROE into its components using a method pioneered by DuPont in the 1920s.
The DuPont model for return on equity separates the calculation into five different components.
Using this model, let's see what gives National Oilwell Varco a 5% edge over Baker Hughes in the last year.
In reality, National Oilwell Varco's 5% edge over the past 12 months is its better EBIT margins. The difference in their equity multiplier numbers is negligible, and the differences between interest burden, tax efficiency, and asset turnover pretty much wash each other out.
Making sense of the numbers
We could just say better margins and walk away, but looking deeper these numbers seem a bit puzzling. One would assume the two companies' differences would be relatively similar on interest burden and equity multiplier basis, but NOV's interest burden suggests its debt is a much smaller part of the capital structure than indicated by its equity multiplier.
In fact, National Oilwell Varco has more cash on its balance sheet than debt, and a large portion of its liabilities is tied up in what is called unearned revenue. These are down payments for big-ticket items such as drilling rigs and floating production, storage, and offloading facilities, that the company has yet to complete, so that revenue cannot be booked at this time and is considered a liability. However, this is a good kind of liability, as it suggests the company is receiving orders for its products. Over the past five years, NOV's unearned revenue has grown by more than $2 billion, suggesting that customers are repeatedly signing up for new equipment.
When we consider the components of returns and look back at Baker Hughes' historical returns, it becomes apparent the company is much more sensitive to industry cycles than National Oilwell Varco. One of the largest revenue sources for Baker Hughes -- well completion in North America -- has been weak because everyone and their mother tried to offer services for hydraulically fracturing a shale well. To be fair, though, this part of the business has improved significantly over the past year or so as some weaker companies have bowed out.
What a Fool believes
Based on the simple return on equity numbers, National Oilwell Varco appears to be the better investment. Even more encouraging is that the simple return numbers don't tell the entire story, and the deeper you dig the better the numbers look for NOV. Baker Hughes might fare much better if oil prices sharply increase over the next couple years, but someone looking for a strong investment built to stand the test of time is better off taking the company that isn't as dependent on commodity prices to succeed. Without all of those distractions, investing in these two companies sure seems a lot simpler.
The Motley Fool recommends National Oilwell Varco. The Motley Fool owns shares of National Oilwell Varco. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.