Monday, November 30, 2009

Beyond ROE: Return on Net Operating Assets (RNOA)

Many investors rely on Return-on-Equity (ROE) to gauge a firm's ability to generate profit from each dollar of equity; a somewhat fundamental determination when assessing the attractiveness of owning a piece of that equity. The problem is, ROE is calculated as net income divided by average stockholders equity, meaning that you have no idea the extent to which leverage played a role in the returns generated for shareholders. In the aftermath of the credit bubble, it should be apparent that not all returns are created equally. For instance, had you been an investor in Merrill Lynch around say, 2006, you may have been lulled into complacency by the firms ridiculous returns-on-equity; oblivious unfortunately to the fact that MER's performance was merely the result of massive amounts of leverage. Fortunately, through calculation of a firm's Return on Net Operating Assets (RNOA), we can isolate the portion of ROE attributable to the operations of the business (the portion that matters).

The general concept behind RNOA is that ROE= Operating Return + Nonoperating Return. As I've said, investors should focus on the operating portion of return, which is calculated as follows:
Operating Return (RNOA) = Net Operating Profit After Taxes (NOPAT) / Average Net Operating Assets (NOA)

The calculation of RNOA requires you be able to differentiate between the operating, and nonoperating items on both the balance sheet and income statement. This should be somewhat easier to do with the income statement, just because although GAAP doesn't require it, most companies will break out their operating results on their financial statements. Management tends to be judged based on the firms operating results, so this shouldn't be surprising. I'll refer to Dell's most recent full year results to illustrate the RNOA calculation.

Step 1: Calculate NOPAT
For FY '09, Dell logged pretax income of $3324M, and income tax expense of $846M, resulting in an effective tax rate of 25.45% (846/3324). Dell posted operating income of $3190M; therefore, applying the 25.45% tax rate, we can state that Dell's NOPAT is $2378M ($3190 X (1-.2545) ). 

Step 2: Calculate average net operating assets (NOA)
First of all, Net Operating Assets =  Operating Assets - Operating Liabilities. The components of each category are listed below.
Operating Assets
Cash/Cash Equivalents
Accounts Receivable
Prepaid expenses
Other Current Assets
Property, plant and equipment (net)
Capitalized lease assets
Natural Resources
Equity method investments (unless unrelated to the core business)
Goodwill and other intangible assets
Deferred income tax assets (current and long term portions)

Other long term assets

Operating Liabilities
Accounts Payable
Accrued Liabilities
Deferred income tax liabilities (current and long term portions)

Pension and other post-employment obligations

Dell's 2009 and 2008 NOA are $6488M and $7501M, respectively. The average of these two numbers is $6995M. Therefore:

= $2378 / $6995

This compares with a 2009 ROE of:
ROE= Net Income / Avg Stockholders Equity
= $2478M / $4003M

A conclusion which can be drawn from these results is that only 55% of Dell's ROE (34/61.9) is attributable to operations. I'd generally like to see a higher ratio of operating to nonoperating return; however, Dell's 34% RNOA is substantially higher than the 10% average RNOA for publicly traded companies. A further examination into Dell reveals that it's debt-to-equity ratio (total liabilities divided by total stockholders equity) is 5.2, meaning that for every dollar of equity, dell has $5.20 worth of debt. This high debt to equity ratio partially explains the juiced ROE number, and should probably be monitored by investors.

*no positions
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  1. It would be impossible to compare different companies using this calculation because of the rising importance of intangible assets.

    The only time that intangibles hit the balance sheet is when one company buys another. 70% of the average acquisition is intangible: 23% is booked to specific intangibles such as customer lists and brands. 47% is booked to goodwill.

    Thus acquisitions can lead to very different total "asset" bases of very similar companies.

    Until we get uniform accounting for intangibles, any kind of return on asset calculation will have limited use.

  2. I agree, there's also the issue of internally generated intangible assets - Coke's "secret formula" being a famous one - which never appear on the balance sheet.