Investors use a variety of metrics to determine the health of companies. One common metric used is

return on equity (ROE), which is defined as a company's net income (or profits) divided by shareholders' equity. This ratio quantifies the company's effectiveness in using its equity to deliver profits, but it cannot be used in isolation, as it is directly dependent on the company's debt levels. If a company's debt-equity ratio (D/E ratio) is high, then a high ROE is not as impressive as it may seem.

Procter & Gamble's Historical ROE

Procter & Gamble Co. (NYSE: PG) is one of the world's largest consumer goods companies, with well-known brands including Tide, Pampers and Ivory soap. Procter & Gamble has recently struggled to grow its stock price and, in the midst of an internal transformation, has named David Taylor as the company's new chief executive officer (CEO). While Procter & Gamble has struggled, key competitors Colgate-Palmolive, Kimberly-Clark and Clorox have outperformed the company in a variety of areas, including ROE.

Over the past three years, Procter & Gamble's average ROE is 15%. Although this is in line with the typical consumer goods ROE of 13%, it is massively surpassed by Colgate-Palmolive's ROE of 133.5%, Kimberly-Clark's 96.2% and Clorox's 415.2%. On the surface, the companies appear to be delivering superior value to their shareholders.

However, each of these companies is highly leveraged, greatly distorting its ROE. Colgate-Palmolive has an average D/E ratio of 698 over the previous three years. Kimberly-Clark's average D/E ratio over this time period is 869, and Clorox's is 2,982. In comparison, Procter & Gamble's average D/E ratio for the past three years is 107, which is in line with the industry average of 109.

Return on Assets (ROA) as a Tool to Compare Growth

Another valuable metric that investors can use to determine how effectively a company is using its resources is return on assets (ROA). ROA is a company's net income divided by all of its assets, including inventory, property and equipment.

Over the past three years, Procter & Gamble's ROA of 7.2% has considerably lagged the ROA of its competition. During this time, Colgate-Palmolive's average ROA was 16.9%, Clorox's was 13.4%, and Kimberly-Clark's was 10.1%. Thus, even though these companies are highly leveraged compared with Procter & Gamble, each of these companies is delivering superior income in relation to both equity and assets, which is in line with their higher stock prices.

Procter & Gamble ROE Projections

While its competition's ROE and ROA have remained fairly stable over the past three years, both of these metrics have declined for Procter & Gamble in the last year: ROA was 5.4% (falling from 8.1% for the previous two years), and ROE dropped to a disappointing 11.3% (from 16.8% over the previous two years). This is directly driven by the company's 40% drop in net income in the past year. Net sales shrank by 12% while organic sales declined by 1% over the past quarter.

Procter & Gamble has divested some of its less-profitable brands and restructured operations to decrease expenses and drive profit growth. These reorganization efforts have already decreased the company's asset base by 10%. In turn, Procter & Gamble's shareholder equity has declined by 10%. Assuming that both the company's assets and shareholder equity will remain constant, the key driver for ROE and ROA growth will be an increase in profits.

The three-year average of Procter & Gamble's net profits is about $10 billion. This average is a very rough estimate because it includes one-time restructuring costs and revenue from divested businesses. For the sake of this discussion, it is assumed that these negate each other. Competitor Unilever recently announced a 5% increase in sales. If Procter & Gamble can deliver a similar increase in sales and profits, this would amount to an ROE of 16.8% and an ROA of 8.1%. With all other things held constant, continuing to deliver 5% sales and profit growth for another year would drive ROE to 17.7% and ROA to 8.5%.

Procter & Gamble must achieve sustained profit growth in order to bring its ROA and ROE in line with its competition.

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