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投资有道
注册时间: 2005-03-22
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Rules of the ratio game
Q: In your Ask Matt column regarding Harley-Davidson, you discussed return on equity (ROE). Why is ROE more important than other ratios, such as return on invested capital?
A: Financial ratios are like neckties: They come in countless colors, sizes and styles, and everyone has their own favorite.
Just as some people prefer bowties, some investors prefer to study price-to-earnings ratios (P-Es) over anything else. And as some people wouldn't be caught dead in a polka dot tie, some investors don't like to look at return on equity.
Equating financial ratios to ties may be simplifying things a bit, but it's really a similar situation. There are literally hundreds of financial ratios. They allow investors to compare companies against each other based on everything from debt levels to valuation and management effectiveness.
If you're curious about how many financial ratios there are, a great site is Reuters Investor. You can see all the ratios for General Electric, for instance.
By now you're probably guessing what I'm about to tell you: No one financial ratio is better or worse than another. In fact, it's usually best to use several ratios to get a complete picture.
Some investors like to study return on equity as a measurement of management effectiveness. The ratio does show how much net income the company is extracting from the amount of equity capital that's been plowed into the business.
Return on equity (ROE) is measured by dividing a company's net income (from the income statement) by its shareholders' common stock equity (from the balance sheet). This is a useful tool, especially if you want to compare managements of several companies against each other.
But there are also diehard supporters of return on invested capital (ROI). Return on invested capital goes a step beyond ROE to measure how much net income the company is generating based on all the capital at its disposal, including both debt and equity. Return on invested capital is calculated by dividing a company's net income (from the income statement) by the sum of a company's shareholders' equity (from the balance sheet) plus long-term debt (from the balance sheet).
For instance, a company carrying loads of debt may look great if you just look at the return on equity, because it's using borrowed money to generate outsized returns. However, its return on invested capital may be low, due to the heavy debt.
Let me explain with an example. Imagine that you're starting a business and you're trying to choose between two people to be a business partner: Mr. Savings and Mr. Debt. You've decided to make your decision based on how financially successful they have been individually.
Both Mr. Savings and Mr. Debt earn $70,000 a year from salary and investments. They both also have the same net worth: $300,000 (a person's net worth is equivalent to a company's equity). That means both have a return on equity of 23%.
But let's say Mr. Savings has a net worth of $300,000 because he has assets worth $300,000 and no debt, while Mr. Debt has a net worth of $300,000 because he has $200,000 in long-term debt and assets of $500,000. If you look at this way, Mr. Savings has a return on invested capital of 23% while Mr. Debt has a return on invested capital of just 14%.
Does that mean Mr. Debt is not as savvy managing his money? Not necessarily. And the same goes for companies. Debt is not necessarily bad. Sometimes the smart use of debt can boost a company's returns. However, if the company is using debt and not getting a greater return than a company that is debt free, you might want take a closer look.
So, when do you use return on equity versus return on invested capital? Typically, I will start by looking at the company's debt to equity ratio. If that ratio is higher than the industry average, I would probably evaluate the return on invested capital ratio. However, if the company doesn't have much debt, then studying return on equity is probably fine.
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