CLASSES TO GO!

1. CLASSES TO GO! 2B or Not 2B: Return on Equity Ronald Bruyn, MBA BIVAB Associate Director

2. Disclaimer • The information in this presentation is for educational purposes only and is not intended to be a recommendation to purchase or sell any of the stocks, mutual funds, or other securities that may be referenced. The securities of companies referenced or featured in the seminar materials are for illustrative purposes only and are not to be considered endorsed or recommended for purchase or sale by BetterInvesting™ National Association of Investors Corporation (“BI”) or the BetterInvesting Volunteer Advisory Board, its volunteer advisory board (“BIVA”). The views expressed are those of the instructors, commentators, guests and participants, as the case may be, and do not necessarily represent those of BetterInvesting™ or BIVA. Investors should conduct their own review and analysis of any company of interest before making an investment decision. • Securities discussed may be held by the instructors in their own personal portfolios or in those of their clients. BI presenters and volunteers are held to a strict code of conduct that precludes benefiting financially from educational presentations or public activities via any BetterInvesting programs, events and/or educational sessions in which they participate. Any violation is strictly prohibited and should be reported to the President of BetterInvesting or the Manager of Volunteer Relations.

3. Today we’ll learn: • What is Return On Equity (ROE)? • What are some of the problems in interpreting Return on Equity? • How can Return on Equity be distorted on the SSG? • Why should we be careful in applying ROE to our judgments?

4. What is Return on Equity (ROE)? A measure of management’s efficiency.

5. Return on Equity (EPS / book value) 5.6%

6. Analysts (but not Value Line) define Return on Equity as net income (after taxes) divided by shareholder’s equity Net income after taxes/shareholders equity x 100 = 5.8% ROE

7. EPS/Book Value .59/10.45 x 100 = 5.6% ROE The Value Line Calculation: EPS/Book Value .59 / (9.78+10.45) x 100= 5.8% 2

8. BetterInvesting and analysts: slightly different ways of calculating ROE, BUT the results are similar.

9. ROE on Value Line Return on Shr. Equity 5.8% EPS/Book Value .59/(9.78+10.45)=5.8% 2

10. What is Book Value? Actual value of the assets of a business. Another term for shareholder equity

11. Book Value • Total assets minus total liabilities minus intangible assets • Looks backwards • Not accurate in some industries • Affected by leases • Affected by intangible assets

12. Where do we find Book Value? Book Value 10.45 Book Value 10.45

13. Reminder: Value Line uses ROE = EPS divided by AVERAGE book value per share (an average of beginning book value and ending book value)

14. BetterInvesting uses: EPS divided by ENDING book value per share

15. Return on Equity • Profitability • Asset Turns • Leverage

16. What is profitability? • Section 2A - profit before taxes • Section 2B - after taxes, not before taxes (as in 2A).

17. Is it good to increase profitability? YES!

18. What are asset turns?

19. Asset turnover is industry specific! The amount of inventory the company can sell relative to its asset base or How often a company turns over its assets or inventory in a year.

20. Is it good to increase asset turns? Yes! (but difficult)

21. What is leverage? Leverage is debt.

22. It it good to increase leverage? MAYBE!!

23. Debt can help a company expand BUT Too much debt can be a problem!

24. Debt can help a company grow • Too much debt can destroy an unstable company

25. Let’s relate profitability, asset turns and leverage to our definition of Return on Equity.

26. ROE = Profitability x Asset Turns x Leverage • Profitability = Income divided by Sales • Asset Turns = Sales divided by Assets • Leverage = Assets divided by Equity

27. Now for some math… Income Sales Assets Sales Assets Equity ROE Or Profitability x Asset Turns x Leverage = ROE

28. Notice that some of the items cancel out. Income Sales Assets Sales Assets Equity This leaves us with our original equation: Income / equity Income divided by equity = ROE ROE

29. Are all three terms equal? Increasing profitability is good. Increasing asset turns is good. But.. Is increasing debt necessarily good?

30. With this in mind, let’s go back to our Return on Equity formula.Let’s see what happens if we increase each item separately.

31. Profitability x Asset turns x Leverage • Let’s assume: • Profitability = 2 Asset Turns = 2 Leverage =2 • 2 x 2 x 2 = 8 ROE • Let’s increase profitability to 4 • 4 x 2 x 2 = 16 Increasing profitability increases ROE

32. Profitability x Asset turns x Leverage • Let’s assume: • Profitability = 2 Asset Turns = 2 Leverage =2 • 2 x 2 x 2 = 8 ROE • Let’s increase Asset Turns to 4 • 2 x 4 x 2 = 16 Increasing Asset Turns Increases ROE

33. Profitability x Asset turns x Leverage • Let’s assume: • Profitability = 2 Asset Turns = 2 Leverage =2 • 2 x 2 x 2 = 8 ROE • Let’s increase Leverage (debt) to 4 • 2 x 2x 4= 16 Increasing Leverage (debt) Increases ROE

34. All three increases produced the same result but is each increase of the same quality? • Profitability increases are good • Asset turn increases are good • Debt increases may not be good

35. CAUTION!! • Return on Equity can be complicated and deceptive!

36. Up is not always good and down is not always bad! • Increasing debt may cause rising Return on Equity. • Decreasing debt may cause falling Return on Equity.

37. Can we spot which factor is causing the change in ROE? Maybe…

38. Other factors can also influence Return on Equity… Acquisitions and mergers. Expensing costs for research and development under the new accounting rules.

39. When can we safely use ROE? • When a company consistently carries no debt • When we’re willing to do the research

40. Here’s the bad news! • 2B is complicated. • 2B is not reliable as a simple answer to efficiency. • Up may not always be good and down is not always bad.

41. Today we learned: • Two definitions for Return on Equity, which produced similar results. • Some of the problems in interpreting Return on Equity • How Return on Equity can be distorted on the SSG • Why we should be careful in applying ROE to our judgments

42. Sources • NAIC Stock Selection Handbook by Bonnie Biafore • Return on Equity Motley Fool • Working with Financial Statements www.usoiuxfalls.edu

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