America's homebuilding industry has a major impact on the economy. Building the average single-family home as of 2014 creates nearly three jobs and pours more than $100,000 into the economy in taxes alone. The industry also can be very lucrative, as corporate homebuilders typically earn nearly $60,000 in profit before taxes on the average home built in the United states.
That being said, not all homebuilders are equal when it comes to reinvesting profits to ensure strong returns for their investors. Let's look at this issue by comparing the return on equity, or ROE, at top homebuilding stocks KB Home (NYSE:KBH) and Lennar (NYSE:LEN).
Building a foundation
Using ROE as our base helps to determine how well a company is generating returns for shareholders on the equity they have invested. The simple formula is a company's net income divided by the average shareholder equity. It's not a perfect gauge -- more on that in a moment -- but it's a good starting point.
The following chart shows the ROE of KB Home and Lennar.
KB Home's ROE is 16.17%, while Lennar comes in at 12.10% over the last twelve months. We could call it a day and declare KB Home the winner, but some things can skew this metric, including debt, writedowns, stock buybacks, and even deferred tax assets. Let's build a better model.
Building a better model for KB Home and Lennar
We'll use a five-step DuPont Model to deconstruct both companies' returns. The following chart notes the formula for each ratio, as well as what we want to see.
I've taken these five steps and computed the various ratios for both KB Home and Lennar in the following chart.
Here we see that Lennar actually has much better pre-interest, pre-tax margins than KB Home; it is also less burdened by interest and has less leverage. Meanwhile, KB Home hasn't paid a dime in taxes over the past year, so it's very tax efficient to say the least. However, even with these adjustments the model points to the fact that the ROE being generated by KB Home and Lennar Corporation's ROE using the DuPont Model doesn't change all that much. Still, there are some curious issues worth a closer look.
One of the reasons KB Home's returns are better is because it has higher leverage, which gives it the ability to generate higher returns on equity than Lennar. That said, KB Home's use of debt to generate excess returns isn't necessarily a bad thing, as long as it avoids excessive debt that could cause liquidity issues. However, it is something investors will need to keep an eye on in the future. It is entirely possible that the company's stronger returns will grow its net income to the point where its interest burden and leverage ratios come down.
The other area impacting the returns of KB Home are taxes as the company currently doesn't pay them. By digging a little deeper into the company we find that it has generated net deferred tax assets of $844 million. These were generated from losses the company sustained after the housing bubble burst. According to KB Home this is enough to potentially offset $2.1 billion in future taxable income. On its second quarter conference call management said that it expects to reverse the deferred tax valuation allowance by the end of this year, which will have an impact on the company's future returns. Once this reversal is complete the asset would be added to the company's shareholder equity and would more than double shareholder equity, as the following slide shows.
This would actually reduce KB Home's net debt-to-capital ratio from 74% to 57%. However, the added equity would also slice the company's ROE to 6.7% if the reversal was done today. This suggests that KB Home's currently higher ROE might not be sustainable for the long term.
When comparing potential investments it's important to dig into what the numbers are really saying. In this case, KB Home appears to be earning its investors a better return, but those returns are boosted by its leverage and its deferred tax asset. That doesn't mean we should declare Lennar the winner just yet, but it does show that headline numbers don't always tell the whole story.
Matt DiLallo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.