Like many individual investors out there, my first lesson into stock investing focused on the key metrics. Within a few hours I felt like a Wall Street insider – throwing around previously unfamiliar terms like P/E and current ratio. The secret to investing was seemingly simple.
Step 1: Identify those companies with superior metrics relative to their industry peers.
Step 2: Profit!
However, over time I’ve learned how things are a bit more nuanced than they are at face value, and a deeper understanding of what influences certain metrics is necessary to make intelligent investing decisions. Take for example the return on equity (ROE) metric. What a neat little ratio! It’s so easy to calculate:
Net income / owner’s equity
This literally tells an investor how much profit the company generated for each dollar of shareholder investment. It’s a very popular measurement of management’s ability to maximize shareholder return. It stands to reason that as an investor I want a company I own to have the highest ROE possible. Well … maybe not exactly. I’ll explain by comparing three industrial companies with similar products: Deere & Company (NYSE:DE), Caterpillar Inc. (NYSE:CAT), and CNH Global NV (NYSE:CNH).
At first glance, Deere & Company (NYSE:DE) appears to be the best investment based on ROE. I’ve calculated all metrics using 2012 annual report data for each company.
Easy enough. Time to contact my broker and then sit back and look ahead to that next black-tie party where I can gloat over my obscene profiting due to proprietary investing acumen. Or, I could take a deeper look at this picture to gain greater insight. As mentioned before, ROE is a function of net income and stockholder equity. Net income is a hard figure; it can’t really be manipulated by management. Certainly management’s effectiveness at their job will impact net income, but at the end of the fiscal year it is what it is. Equity, on the other hand, can be easily manipulated. A very basic formula of financial accounting is:
Assets = liabilities + owner equity.
It’s pretty straightforward; just think about buying a $100,000 house. Assume a buyer puts 10% down and takes out a mortgage to pay the rest. The buyer will have a $100,000 house (an asset), a $90,000 mortgage (a liability), and $10,000 of ownership (equity). It becomes clear that management can reduce shareholder equity by increasing debt. Since equity is the denominator in the ROE equation, a reduction in equity will increase ROE assuming net income is unchanged.
Considering a few more related metrics will paint a more complete picture in comparing these three companies.
Return on sales (ROS) = net income / sales
– Commonly referred to as net profit margin
Return on assets (ROA) = net income / assets
– Measures the amount of profit for each dollar invested in assets
Asset turnover = sales / assets
– Measures the amount of sales generated from each dollar invested in assets