Dear Mr. Berko: I’m writing for our investment club and requesting your explanation of return on equity, price-earnings ratio and net profit margin. Could you please use untechnical English? We had a certified public accountant explain this to us last month, but he was too technical for us. — HG, Charlotte, N.C.
Dear HG: This subject is as boring as watching iron rust, milk spoil and water evaporate, but here goes.
In the tedious world of accounting, “equity” is the difference between a company’s total assets and its total liabilities. And return on equity calculates how many dollars of profit a company generates with each dollar of shareholders’ equity. Here’s how it calculates: Return on equity equals net income divided by shareholders’ equity.
Assume that AZBZ Corp. — which designs, manufactures and markets a fully functional artificial appendix — posted $5 million in net income last year. If AZBZ’s shareholders’ equity equaled $20 million, we would, using the above formula, divide $5 million by $20 million, giving us 25 cents. This tells us that AZBZ returned 25 cents of profit for every $1 of shareholders’ equity, giving the company a return on equity of 25 percent.
Some consider return on equity to be more a measure of efficiency than a measure of profit. When the ROE rises, this suggests that AZBZ is increasing its capacity to produce profit while reducing its need for capital. Return on equity also measures how well AZBZ’s management is using shareholders’ capital. Some would say that the higher the ROE the better it is for shareholders. And a falling ROE can indicate a problem.
But it’s important to recognize that when shareholders’ equity declines, the ROE rises. Thus, share buybacks and asset write-downs can artificially boost ROE, as will a high debt level. Certainly, as AZBZ’s debt increases, its shareholders’ equity decreases (as a percentage of total assets) and the ROE becomes higher. Some industry sectors — e.g., pharmaceuticals, utilities, heavy manufacturing and food services — tend to have higher ROEs than others. So when comparing ROE, it’s generally more meaningful among companies within the same sector.
Some investors are more comfortable using a price-earnings ratio. Here’s how we determine a P/E. Assume that AZBZ stock trades at $10 a share and last year the company had net income of $1 per share. To calculate the price-earnings ratio, we take the trading price of a company’s stock and divide it by its earnings per share. So in this instance, AZBZ’s price-earnings ratio is 10-to-1. In essence, the P/E tells us the dollar amount an individual must invest to receive $1 of that company’s earnings. Usually, a high P/E suggests investors expect high earnings growth in the future. A low P/E can indicate that AZBZ is undervalued or the company isn’t doing well relative to past trends. And sometimes a low P/E can tell us that a company is in trouble. Price-earnings ratios also vary by industry sector. Companies in the biotech industry, for example, usually have very high price-earnings ratios, whereas utilities trade at lower ratios. We only compare birds of a feather together. !
So comparing a P/E is meaningful only when doing so among companies in the same sector.
Though the above metrics are useful, I only use them in conjunction with net profit margin when I research a company. Simply put, NPM tells me how much profit a company earns per $1 of sales. In my opinion, the NPM is the best way to determine a company’s management’s skills. To determine NPM, we need two figures: sales and net income. Then we divide net income (AZBZ made $5 million) by revenues (AZBY’s revenues were $25 million) and multiply this number by 100. The result is expressed as a percentage, and in this case, the net profit margin is 20 percent. So for every dollar of sales, AZBZ (after all costs, expenses, depreciation, etc.) nets 20 cents. If two companies are in an identical business and one company has an NPM of 15 while another has an NPM of 25 percent, I’d rather own the latter because it tells me management may be more efficient.
Please address your financial questions to Malcolm Berko, P.O. Box 8303, Largo, FL 33775, or email him at mjberko@yahoo.com. To find out more about Malcolm Berko and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.
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