This is another one of those “holy COW” articles I’ve read. And yes, I know I’m becoming my mother, LOL. 😉 Perhaps this is merely the reaction of a guy (me) who once spent a very little time in the financial world (at Smith Barney in 1987), but whose world has for the last several years consisted of diapers, minivans, soccer practices, et. al. – and who is aghast both at what he didn’t see coming, and also what’s happened since last I was really paying attention. Either way, my jaw is officially on the floor.
Why? Because of this. I was directed by the ever-wonderful Boing Boing (Cory Doctorow’s group blog) to the above-linked post on another blog, which in turn referenced this post at something I’d never heard of previously called the Deloitte Center for the Edge (sounds like something dreamed up by a screenwriter, if you ask me, but apparently it’s real). The Deloitte page is apparently the source, but the post at Jon Taplin’s blog (first link in this paragraph) does the best job of explicitly laying it all out in layman’s terms.
Essentially, what it provides is a perspective I think most people lack – and probably don’t even understand or realize is worth looking into, either. Certainly I was not paying attention to it. The Deloitte piece (and Mr. Taplin’s piece referring to it) concern two different types of analysis of the financial strength and health of a company, ROE (Return on Equity) and ROA (Return on Assets). Each is a measure of a company’s ability to generate income, but it’s compared to two very different things. ROE is essentially profit-per-dollar-invested. It’s figured by taking a company’s total net income in a given period (usually a year), and dividing it by the total amount that shareholders have invested in the company (in other words, how much equity – how much shareholders own of the company, total share value plus some odds and ends) in the same year. ROE = net income ÷ total equity. It’s supposed to be a measure of a company’s ability to generate profits-per-share for investors, because since “equity” represents shareholder investment, the shareholders are obviously the ones who would care about what sort of return they’d get for their money. Fair enough, as far as it goes.
But the shocker of this article is that it (ROE) doesn’t go nearly far enough. Or perhaps, said better, that it’s not looking at a wide-enough measure of the financial strength (or even health) of a company. That’s where ROA comes in. What the ROE figure doesn’t take into account is the underlying health of the company. It only measures for a given period whether that company turned profits for its investors (or how much profit per investor dollar). In a sense, it’s an artificial figure, since it measures net income (which is unquestionably a “hard” figure; one worth looking at) against an arbitrary one (how much money investors have (equity) in the company. But it says nothing about how large the company itself is, how much debt it carries or how much it has in assets.
That’s where ROA comes in. ROA reveals what a company earns expressed as a function of its total assets. ROA is calculated by finding the company’s total assets for the period in question (usually available somewhere in the financial report or elsewhere on the company web site), and dividing it not by investor equity, but by the company’s total assets. The difference is rather startling, and shows one of the real weak spots of the current economy. Taplin uses GM as an example. I know, I know – when I read that GM was to be the example, I worried that he was stacking the deck. After all, people have been complaining that GM has been going under for years, and this is the same GM which is now owned by the US taxpayer (for now). That’s like using Mark Sanford as an example of rational decision-making and marital fidelity, LOL. But bear with me (and Taplin) here:
Taplin looks at the 2003 year for GM. 2003 was still within the housing and credit bubbles. Alan Greenspan was still at the fed, keeping both the fiscal and the monetary pedals to the metal in order to keep the house of cards from collapsing completely, and though the tsunami was coming, it hadn’t hit yet. All the balls were still in the air, and as far as automobiles, especially in Republican-voting exurban areas (like the one I live in, sadly), the country’s appetite for gas-guzzling behemoth SUVs was undiminished. GM appeared to have made the right moves (at the time) by getting heavily into the SUV game; they were selling like hotcakes. In 2003, GM’s net income was 3.822bn (billion) dollars. ROE says that 3.822 divided by shareholder equity, which was $16.041bn, gives us a figure of 0.23826… In other words, 23.8%! That’s excellent – it means that for every dollar invested in the company, GM made 23¢ in 2003 alone. Yahoo! – strong buy, right? Well, what if you know that the total asset figure is $448.507bn? So what, it’s just a number, right? Well, the ROA calculation would be the above 3.822bn divided not by equity of 16.041, but by assets of 448.507, for a figure of .008521, or 0.85%. Read it again – that’s eight-tenths (OK, 8 and a half, but still) of ONE percent, meaning that for every dollar of assets (that’s everything: property, cash on hand, equipment, right down to the phones and desks – a total of $448.507bn), GM made less than one cent in net income. Yikes.
Neither one of these figures is a magic bullet. Just as no one should rely upon ROE when deciding whether to invest, no one should rely solely on ROA, either. The important point here, though, is twofold: one, that ROA is a rarely-used figure by anyone in the financial world (at least when talking to suckers investors), and two is obviously the discrepancy between the apparent health/strength of the same company, looked at with two metrics using the same data. Again, here, I’m aware that even though this was 2003, before the bubble had burst, we’re still looking at the ultimately-doomed GM, which seems like a poor choice (though in many ways, I would argue, those same reasons make it the perfect choice for understanding what these articles tell us – and I agree – we must understand). So I did a little experimentation. I went to another American company which also personifies what many think of as a rock of American corporations – GE. I’m too lazy to try to dig up 2003 numbers for GE, but I got hold of last year’s figures (2008), and we’ll see what those numbers look like.
For 2008, GE’s total net income was $17.41bn. Total shareholder equity was $104.665bn, and finally, assets for 2008 were $796bn. That means that ROE was 17.41(income) divided by 104.665 (equity), for a figure of 0.1663, or 16.63%. Not as “wow” as GM in 2003, but then GE is more stable and secure, right? I mean, Jack Welch ran them! Unfortunately, ROA, meanwhile, was 17.41 (income) divided by 796 (assets), for a figure of 0.021871, or 2.18%. Ouch. Still more than double the ROA of GM (at 0.85%), but far less than healthy. Why such huge discrepancies in the ROE and ROA? Where does all that money GO? Short answer: debt. It’s not just American consumers or even the federal government that is addicted to debt. It’s also our corporations, which are supposed to be the engines of prosperity and financial stability. Hah! As Taplin goes on to explain, the fundamental equation of a corporate balance sheet is assets = liabilities (debt, essentially) + shareholder equity. And that if a company carried no debt whatsoever (removing the “liabilities” portion of the above equation completely), then assets would theoretically be equal to shareholder equity. No company can – or rather, no company should try not to – operate with no debt ever, just as you would not expect to have to pay cash for your house or car. Some people can and do, but their numbers are very small. Purchases which are both vital to operations (corporate or personal) and very expensive are expected to be purchased via credit (taking on debt). But any time you take on debt, you have to be able to “beat the spread.” In other words, you have to have figured out with certainty that doing so will allow you to make money which exceeds that which is lost in interest to servicing your debt. That’s how business stays IN business.
But in the last forty years or so – certainly the last 25 – American corporations, fueled by “innovative products” pushed by Wall Street, and coupled with a lack of regulation or oversight of such things by the federal government, have artificially inflated their ROE (a number they know investors look at to judge the financial health of a company) by taking on more and more debt, which shows up only if you look at ROA — which continues to look worse and worse with each new debt obligation. Taplin traces the transition of judging the financial health of a company based on its ROA to doing so based on its ROE to the creation of the junk bond by none other than Michael Milkin in the late 1970s. This allowed companies to leverage themselves well beyond where they were capable of repaying their debt, creating a spiral whereby the payments to service the debt alone assumed near self-sustaining proportions. So if a company borrowed more money in a given year, its ROE might artificially rise as that money was used in the short term…but with each infusion of borrowed money, more and more of the company’s assets were used to service the debt, further reducing the ROA.