UnThreaded | Threaded | Whole Thread (6) | Ignore Thread Prev Thread | Next Thread
Author: PhoolishPhilip Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 1933  
Subject: Dumb Question Date: 1/30/2003 2:01 PM
Post New | Post Reply | Reply Later | Create Poll . Report this Post | Recommend it!
Recommendations: 0
OK, I know this is probably basic but I have to ask it. How can a company consistantly achieve a ROE significantly higher than the growth of net income?

PhoolishPhilip
Print the post Back To Top
Author: educatedidiot Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1611 of 1933
Subject: Re: Dumb Question Date: 1/30/2003 4:09 PM
Post New | Post Reply | Reply Later | Create Poll . Report this Post | Recommend it!
Recommendations: 1
OK, I know this is probably basic but I have to ask it. How can a company consistantly achieve a ROE significantly higher than the growth of net income?

Just break ROE into its two components: income divided by equity, and the answer becomes more clear. For ROE to exceed net income growth, book value (equity) must shrink without negatively impacting income growth.

Here's two possible scenarios:
1) The company is using all of its earnings to repurchase shares. Cash, and hence equity, will be reduced thus giving an added boost to ROE above and beyond the income growth. [Actually, the funny thing about this scenario is that it doesn't matter how the cash is spent -- the company could literally incinerate all of its excess cash and this would theoretically cause ROE to exceed income growth for the year in which the money is burned.]

2) Company takes on more debt. Again, equity is reduced, but income growth won't decline as a result of having more debt. So again, the leverage provides an added boost to ROE.


Print the post Back To Top
Author: ziggy29 Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1612 of 1933
Subject: Re: Dumb Question Date: 1/30/2003 4:17 PM
Post New | Post Reply | Reply Later | Create Poll . Report this Post | Recommend it!
Recommendations: 0
>> OK, I know this is probably basic but I have to ask it. How can a company consistantly achieve a ROE significantly higher than the growth of net income? <<

Well, leverage immediately comes to mind...

#29


Print the post Back To Top
Author: educatedidiot Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1613 of 1933
Subject: Re: Dumb Question Date: 1/30/2003 4:22 PM
Post New | Post Reply | Reply Later | Create Poll . Report this Post | Recommend it!
Recommendations: 0
OK, I know this is probably basic but I have to ask it. How can a company consistantly achieve a ROE significantly higher than the growth of net income?

As for how this is done consistently (I'm guessing this what you were interested in), the easy way would be to pay out a portion of earnings in dividends (or a regular share repurchase program). Another way would be to maintain leverage - i.e. to continually increase debt as the company grows. A company like KO uses a combination of both of these to maintain a ROE above its rate of income growth.

Print the post Back To Top
Author: MadCapitalist Big funky green star, 20000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1615 of 1933
Subject: Re: Dumb Question Date: 1/30/2003 9:13 PM
Post New | Post Reply | Reply Later | Create Poll . Report this Post | Recommend it!
Recommendations: 0
2) Company takes on more debt. Again, equity is reduced, but income growth won't decline as a result of having more debt. So again, the leverage provides an added boost to ROE.

Adding debt doesn't reduce equity. It boosts ROE by increasing net income without adding equity capital to do it.

Print the post Back To Top
Author: ziggy29 Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1616 of 1933
Subject: Re: Dumb Question Date: 1/31/2003 9:28 AM
Post New | Post Reply | Reply Later | Create Poll . Report this Post | Recommend it!
Recommendations: 0
>> Adding debt doesn't reduce equity. It boosts ROE by increasing net income without adding equity capital to do it. <<

In absolute terms, yes, equity doesn't decline just by adding debt. I think what they meant was that equity *as a percentage of working capital* declines...but that does (when profitable) boost ROE. When losing money, though, it can lead to a death spiral.

#29


Print the post Back To Top
UnThreaded | Threaded | Whole Thread (6) | Ignore Thread Prev Thread | Next Thread
Advertisement