Earnings Power Drives Stocks

By Bryn Harman AAA

Equity investors are primarily interested in the earnings power of the companies in which they invest. Other things being equal, the greater the earning potential of the issuer, the greater the upside potential of the stock.

A good way to analyze earnings power is to assess return on assets (ROA) and return on equity (ROE) - two financial ratios that compare a company's earnings to certain balance sheet components. An even better way is to break out these simple ratios into their component parts to see what's really driving earnings power over time. In this article, we'll show you how to calculate this number and make it work for you. (To learn more about company earnings, see Research Report Red Flags and Surprising Earnings Results.)

Return On Assets
ROA is simply earnings available for the common shareholder divided by average total assets over a time period (usually one fiscal year). ROA measures the earnings power of a company's assets - how well the company generates earnings from its asset base. As demonstrated by a simple example, ROA is a very easy ratio to calculate.

Looking at the 2006 financial statements for General Electric, we note that earnings were $20.8 billion, the beginning total asset line was $673.3 billion and the ending total asset line was $697.2 billion.

So, ROA is $20.8/(($673.3+$697.2)/2) or 3.03%.

You can use this tool to compare the current ROA to GE's historic numbers as well as to comparable companies. This is to assess whether GE's earnings power is increasing or decreasing over time. Remember that numbers don't just move on their own - if this number is increasing or decreasing, there must be a reason. (Keep reading about ROA in ROA On The Way and Understanding The Subtleties Of ROA Vs ROE.)

Return On Equity
ROE is the company's earnings the are available for common shareholders divided by average equity. ROE is similar to ROA except that it measures the earnings power of a company's net assets (assets minus debt or other items that aren't common equity). It is a more direct measure of how well the company generates earnings from a shareholder's investments (or the book value of the shareholder's investment). It is therefore the more applicable and more widely used measure for equity analysis compared to ROA. Continuing with GE's financials, we note that in the beginning period, equity was $109.4 billion and the ending period equity was $112.3 billion. ROE is GE's $20.8 billion in earnings divided by average equity, or 18.8%. Just like for ROA, you would then take the ROE and check for any changes in trends and what reasons there could be for those changes. (For more on this, see Keep Your Eyes On The ROE.)

Analyzing Du Pont's ROE Theory
Years ago, the smart people at E.I. Du Pont de Nemours and Company realized they could better analyze the returns of their business by breaking out ROE into a few component parts. Called Du Pont identity or Du Pont ROE decomposition, it is a widely used technique for analyzing ROE. There are a few ways to do this, but we'll look at a simple version of it here.

EAT = earnings after tax or net earnings for the common shareholders
EBIT = operating income (which doesn't consider interest expenses and taxes)

Notice how the numerator and denominators of the four terms cancel each other out:

The first term (EAT/EBIT) could be described as interest and tax burden. It measures the proportion of operating income that is left over for the common shareholders after paying interest on debt and taxes. Other things being equal, profit-loving common shareholders want this number to be as high as possible. In the GE example, EAT for 2006 was $20.8 billion and EBIT was $43.9 billion, so the interest and tax burden was 0.474. In other words, about 47.4% of operating income flowed through to the shareholders after the company paid interest and taxes.

The second term (EBIT/Sales) is described as operating margin. Operating margin is an important accounting measure of revenues less operating expenses (like the cost of goods sold and corporate overhead). Again, business owners love big operating margins, so they prefer this number to be as high as possible. Continuing with GE's financials, operating margin for 2006 was $43.9 billion divided by revenue of $163.4 billion, or 26.9%.

Sales/Average Assets is called asset turnover. Asset turnover is a measure of how efficiently the company uses its assets to produce revenues. Investors want this number to be as high as possible, all other things being equal. Continuing with GE, asset turnover is $163.4 billion/$685.25 billion, or 0.239.

Lastly, Average Assets/Average Equity is called financial leverage. The number is higher if the company has a lot of debt and smaller if the company is more conservatively financed. Other things being equal, the higher this number, the higher the ROE. However, using a lot of debt is risky and common shareholders do not always want their companies to use a lot of debt to finance operations.

Debt can cause a lot of burden on cash flows, not just from interest expense (which hits the income statement directly) but also from principal repayments (which hits the cash flow statement). Also note the relationship between financial leverage and the tax and interest burden. A high debt load increases financial leverage but decreases the income flow after taxes and interest, causing a combination effect on ROE. In our example, financial leverage is $685.25 billion/$110.9 billion or 6.2-times. (To learn more, read Find Investment Quality In The Income Statement, Understanding The Income Statement and The Flow Of Company Information.)

Reconciling all of the above to our original Du Pont formula, we come up with:

ROE = 0.474 x 26.9% x 0.239 x 6.2 = 18.8%

Decomposing ROE in this way tells us how a company uses its resources to generate returns for investors. We would want to calculate the figures for several sequential years to figure out how ROE components are changing over time. This might reveal problems with the company or might demonstrate opportunities to increase ROE in the future. For example, a cyclical company going through a slow period might have dropping asset turnover and margins that ultimately squeeze its ROE from one year to the next. If we believe that business conditions will improve, we might expect margins and/or turnover to improve in the future, which will ultimately mean better internal returns for shareholders. In other words, we might postulate that the company's earnings power will increase in the near future from a currently depressed level. If we are right, and we discover this potential before the masses of equity investors, we might be able to make a good return by buying the stock now.

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