It can be difficult to get a clear picture of how well a company makes use of the resources it has at its disposal. This, however, is an important consideration when examining an investment, as managers who are poor wards of capital will, ultimately, cost money for their investors either in the direct loss of capital or in relatively poor returns.
Indeed, when someone buys shares in a company, he or she is buying a portion of that enterprise. The investor is entitled to his or her pro-rata share of earnings. Regardless of the size of the investment, it is a material commitment of resources on the part of the investor. Moreover, a certain degree of trust is conferred to management. The assumption being that the management team of the selected company will be able to better use the investor’s resources than the investor him or herself could. The investor is expecting a return on his or her investment in the form of distributions (normally dividends) or a higher stock price. A bond investor makes a similar choice, though the expected return is in the form of regular interest payments and a return of the original sum lent to the company when the bond comes due.
Clearly being able to gauge which managements are better at providing a return for investors is valuable. There is no absolute right answer here, but two measures can help guide investors toward those companies that have historically rewarded shareholders: Return on Total Capital and Return on Shareholder Equity. These two statistics are in the Statistical Array on each Value Line report.
Return on Total Capital measures the percentage a company earns on its shareholders’ equity and long-term debt obligations. Value Line calculates this number, which appears in the Statistical Array on every research report, by dividing net profits plus half of the current year’s long-term interest due by the sum of shareholder equity and long-term debt. The general idea of the measure is to see how much a company earns on the money it has been given by outside investors. Companies with high scores are, presumably, better wards of capital.
Return on Shareholder Equity, meanwhile, reveals how much has been earned on just the stockholder equity. Value Line calculates this by dividing net profits by shareholder equity, which includes both common and preferred equity. Again, higher percentages are generally better.
Neither of these measures can be used in exclusion, however. They are best used as a starting point or as a comparison tool. Note that comparisons between companies in the same industry will provide more insight than comparisons between companies in different industries. Indeed, because of the differences between industry fundamentals, some industries will have a preponderance of low scores while others will have large numbers of companies with high scores. That said, using these two measures as a first screen can help to quickly limit the number of companies under review and will, generally, direct investors toward higher quality entities. A recent Return on Total Capital screen turned up companies such as Exxon Mobil (XOM – Free Analyst Report) and Microsoft (MSFT – Free Analyst Report).
It is also interesting to compare these two measures for the same companies, which can provide insights into how well companies are making use of their debt. For example, if Return on Total Capital is going up but Return on Shareholders Equity isn’t following along, or, worse is static or falling, additional debt financing isn’t benefiting shareholders.
Another statistic to consider along with these two is Retained to Common Equity, which is colloquially referred to as the “plowback ratio”. Value Line calculates this measure by dividing net income less all dividends (common and preferred) by shareholder’s equity. It measures the extent to which a company has internally generated resources to invest in the company’s future growth. A high percentage here, coupled with an increasing Book Value, is a clear signs that management is increasing the value of its business. This can help validate both the above measures and provide a degree of reassurance that a business is self sustaining. Like the other two measures, this data point is available in the Statistical Array of each Value Line report.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.