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MANAGEMENT: Is the ROE the best metric a CEO can use on order to assess his/her company's performance?
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Is the ROE the best metric a CEO can use on order to assess his/her company's performance?

By Marwan Emile Faddoul (Managing Partner) and Katherine Lange Johnson

NFG Consulting LLC


002When working abroad, an expat faces many difficulties. On a familial level, there is the strain of moving house and starting new in a foreign country. Related to the business setting, there are the problems associated with learning the foreign culture's norms and operating procedures in the office. From a daily operations perspective, problems with assimilation, cultural adjustment, and added responsibilities can seem overwhelming, but with time many of these problems cease to exist. What remains is the work that needs to be done, and the need to report on performance to the home office.


There are several metrics available to assess the performance of a company, and each provides an idea to both investors and insiders about the health and performance of a company. While net income, or "the bottom line," alone can demonstrate how profitable a company is over time, it is not enough to give the full picture of performance. More information is needed, especially in order to compare one company's performance to another. There are many metrics available in business accounting that can provide a definable picture of performance. These metrics include net income (NI), return on equity (ROE), return on assets (ROA), and return on invested capital (ROIC). This paper will serve to explain the concepts, show the methods for calculation, present the limitations of each metric, and compare, in order to ultimately demonstrate which metric is the best choice in assessing a company's performance.

Of all the metrics available, net income (NI) is one of the simplest to derive, but this simplicity is its main limitation, because a high net income may only demonstrate a high sales volume, and not overall health or performance. Net income is a company's total earnings, calculated by subtracting the cost of doing business, depreciation, taxes, interest, and other expenses from revenues. It is a fair measure of a company's performance over a given time, but it has limitations. One of these limitations relates to the ease with which net income can be manipulated through aggressive revenue recognition or obfuscating expenses. NI fails to take into consideration other aspects to business accounting, such as shareholder equity, total assets, and invested capital and how these elements interact and change over time.


Return on Equity (ROE) provides a more detailed explanation of a company's profitability by adding other variables into consideration. ROE is defined as the amount of net income returned as a percentage of shareholders equity over a full fiscal year. ROE is expressed as a percentage and is calculated as:


Return on Equity = Annual Net Income / Shareholder's Equity


In other words, ROE shows a company's profitability by relating how much money it has made over the year using its shareholders' investments. It also provides evidence of the management's ability to grow the company's value at an acceptable rate. ROE is especially useful when benchmarking profitability across an industry, or when assessing historic growth by averaging the ROE over several years.


ROE has a fundamental limitation because it uses net income as a variable in the equation. When a company is doing well, this is not a problem, as all numbers used in the equation will be positive, so the company will report a positive ROE in addition to a positive net income figure. If the company experiences negative profits, however, then the equation will result in a negative ROE. A negative ROE may seem indicative of a failing company, but it can, in fact, simply render the ROE a poor indicator at the moment. This is because companies can report a negative net income but still have a healthy free cash flow level, which is another indictor of profitability, or may experience a turnaround in the future.


004A company may report a negative net income after a restructuring, merger/acquisition, or after taking on significant debt for other reasons. In 2012, Hewlett Packard (HP) undertook a series of restructuring practices, including layoffs and a failed acquisition. At this time, HP had a net income of -$12.7 billion, which resulted in an ROE of -51%. The following year, however, when net income returned to $5.1 billion, its ROE was raised to 30%.


The US automaker Ford can also provide an example of the limitations of using ROE to assess a company's success. Because the net income used in the equation is a measure of NI before dividends are paid to common stockholders, a change in dividends will skew the equity calculation and cause problems when comparing ROE over time. For example, Ford's ROE from 2012-2014 was reported at 36.58%, 33.81%, and 12.45%. Net income at these same times was reported as $5.6 billion, $7.2 billion, and $3.2 billion, respectively. The correlation between ROE and net income fails for these years because Ford gradually raised its dividends during each of those years.


As a metric for company success, ROE can be a useful figure to benchmark profitability across an industry and to assess the company's growth rate over time. It also provides information about how well the management is using their shareholder's investments to increase value. ROE fails to provide an accurate picture when a company experiences a negative net income, which can happen to even healthy companies that experience short-term losses or downturns in the economy.


Return on Assets (ROA) is another metric used to indicate the profitability of a company, this time adding assets into the equation. It takes into consideration the amount of net income returned as a percentage of total assets, and the equation is written as:

UntitledReturn on Assets = Annual Net Income / Total Assets


ROA works particularly well to show how effectively management is in using its assets to generate higher earnings. In other words, ROA shows how efficiently management can create a large profit from a small investment. ROA is sometimes referred to as Return on Investment.


Assets are anything bought by a firm to increase its value or benefit its operations. In other words, an asset is anything that is believed to generate future cash flow, whether in the near future, like inventory, or in the long run, like manufacturing equipment. The assets of a company are made up of both debt and equity, because both types of financing can be used to fund operations, which in turn are hoped to generate future cash flow.


The ROA figure can tell investors how talented a company is at creating money from money. For public companies, these figures can vary widely, especially among different industries. By comparing past ROA figures to current ROA figures, a company, or an investor, can see how well it is doing at creating more net income from invested capital. ROA, because of its wide variance among companies and industries, is not the best metric to use when comparing relative health and strength across many companies, especially across industries. The metric can, however, reveal internal figures on the strength of the company's ability to make wise investments, and can therefore be an appropriate figure to judge internal health and/or report to the home country. Often, a high ROA is an appropriate indicator that the financial and operational performances of a company are healthy.


It is important to note that while a company may produce a favorable ROE and an unfavorable ROA for the same fiscal year. ROE takes into consideration net income in relation to shareholder's equity. Equity is a measure of assets minus liabilities. ROA shows the relationship between net income and assets. Assets are the combination of liabilities and shareholder's equity. While calculations may reveal a company to have a high ROE, it may simultaneously reveal a low ROA. This may be due to the high amount of debt or liabilities the company is carrying.


There is another metric often used to measure a company's performance, this time taking into consideration more variables than the above-mentioned metrics. Return on Invested Capital (ROIC) is a performance-based metric used to determine a company's efficiency at allocating the capital under its control into profitable investments. In other words, ROIC provides a sense of how well a company is using its money to generate returns. It is always calculated as a percentage, and one simple way to calculate it is:

003
Return on Invested Capital = (Net Income – Dividends) / Invested Capital


There are, in fact, many ways of calculating ROIC, each including multiple variables, but all essentially reporting the same idea about a company's performance at generating net income and allocating it efficiently. Another way to calculate ROIC is to use the operating income, minus the tax rate, divided by the book value of invested capital. Yet another way is to take the Net Operating Profits Less Adjusted Taxes (NOPLAT) divided by the sum of the working capital minus fixed assets. Working capital is a measure cash flow generation and is calculated by taking assets minus liabilities. In any way ROIC is calculated, it is reported as a percentage and is best understood in comparison to the company's Weighted Average Cost of Capital (WACC).


WACC is an attempt to proportionally compare each category of capital within a firm. Sources of capital may include common stock, preferred stock, bonds, and other long-term debt. It is calculated by multiplying the cost of each capital component by its proportional weight, and then deriving the sum of these numbers. A high value of WACC may denote a decrease in valuation. Companies often use WACC internally to make financial decisions, such as the economic feasibility of mergers, acquisitions, or other expansionary opportunities. If an expat manager is hoping to accurately represent the value created within his/her domain, both WACC and ROIC would be helpful metrics, especially when used in tandem.


By comparing ROIC to a company's cost of capital, the company's level of value creation can be determined. Cost of capital varies widely among industries. For example, consider the capital investments associated with an oil company as compared to an ice cream shop. ROIC measures return generated on all invested capital, which means it considers debt as well as equity. After taking cost of capital and both the equity and liability sides of capital into comparison, the higher the ROIC is in relation, the more value that is being created.


Many of these metrics provide a potential investor with information about the financial health and growth of a company. ROE provides potential investors information about the overall profitability of a company, especially if the company has been operating under normal circumstances for several years. ROA tells potential investors a bit more about management's ability to generate money from money, particularly the management's ability to make a large profit from a small investment. ROIC provides a potential investor with more detailed information because it takes into account so many variables. Like ROA, ROIC also demonstrates how well a company can turn invested capital into profits, but ROIC is most useful in telling a complete story, especially when used in comparison to WACC. The comparison will more accurately demonstrate how much value is being created at a company.


The attention and valuation given by potential investors into a company can demonstrate to those on the inside what the outside thinks of them. Investors can add needed capital to a company, which in turn can generate more profit, which in turn can bring in more investment. Maintaining a positive image through these financial metrics can increase investor confidence.


Each metric has its own limitation, however. ROE fails to tell an accurate picture during times of negative net income, something often faced by companies who operate using high investment capital, such as a high-tech company, though it succeeds in portraying profitability. ROA fails when used as a benchmark across companies, though it can provide an accurate look inside a company's performance over time. ROIC is particularly useful in assessing the performance of companies in capital-intensive industries by revealing value creation within the company at large. ROIC cannot, however, tell you exactly where within the company the value is being created.


An expat is often sent abroad when a foreign subsidiary of the domestic company is under-performing. Often, expats begin work well after problems have arisen, and may find themselves mired in both financial discrepancies and difficulties. After spending months trying to piece the problem together, not to mention trying to assimilate into the foreign culture, an expat manager may have only touched on the key problem before performance reports are due to headquarters. By ascertaining the return on equity, the return on assets, and the return on invested capital, an expat manager can easily communicate clear figures about the company's performance. These performance metrics include noteworthy information on a company's growth rate, its efficiency at value creation, and its total value. These metrics can be used to compare a company's improvements over time, and can also be used to benchmark their performance to other companies within the same industry.


In order to answer the question "What is the best metric for a CEO to use in order to know his/her company's performance," it is important to first know a few things about the company, such as size, type and industry. For example, none of these three metrics are the best choice when valuating a start-up company. One of the strengths of these metrics is in their ability to give a picture over time. Start-ups have little to provide when a comparison over time is needed. Instead, valuating a start-up is better done using forecasts of revenue. A large, capital-intensive company with a lot of debt would not benefit from using ROE as a metric of valuation. Under these conditions, calculating ROE will provide misleadingly low returns and not give an accurate picture of the firm's future financial health. Likewise, a company undergoing restructuring will also provide skewed figures on these fronts because of their high amount of debt. Calculating ROIC provides the most detailed assessment, covering variables including debt and equity, adjustments for taxes, and stock and bond investments. Additionally, by comparing it to WACC, it also takes into consideration various capital investment categories. Because of its multi-faceted nature, and detailed description of the value creation of a company, ROIC is the best metric to use in order to assess the performance of a company.


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