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SECTION 2 OF THE SSG: EVALUATING MANAGEMENT

2 EVALUATING MANAGEMENT

Company:Stryker Corporation (SYK)

03/16/08

Chart

Once you have decided from the Visual Analysis on the Front Side of the Stock Selection Guide (SSG) that the company's track record of sales and earnings growth has been sufficiently stable and strong to warrant your consideration, you need to assess if the management team is capable of sustaining the company's growth. This is one of the most important judgments you will make. You want management to be able to produce growth. Growth is usually what causes an increase in the stock's price. Remember, for growth to produce an increase in the stock's price, a company must have superior profit margins from goods and services sold (Pre-tax Profit Margin) and from capital employed (% Earned on Equity).

SECTION A: % PRE-TAX PROFIT ON SALES (NET BEFORE TAXES DIVIDED BY SALES)

If using software called Toolkit, or Stock Analyst, or the BetterInvesting online software, the calculation to determine the percent of Pre-tax Profit on Sales (also known as Pre-tax Profit Margin or PTP) is done by the computer. If you are doing a Stock Selection Guide by hand, you might have to do a two step calculation. If using figures from Standard & Poor's reports to determine the % Pre-tax Profit on Sales, the PTP figure on sales is given. If using Value Line's reports, a two step calculation is needed. VL gives the net profit (after tax profit) figures and the tax rate.

To determine the Pre-tax Profit, use the following formula:
Step 1: Net Profit divided by one minus the tax rate [Net Profit/(1 - Tax Rate)] = Pre-tax Profit
Step 2: Pre-tax Profit divided by Sales x 100 = % Pre-tax Profit on Sales.

By using the Pre-tax Profit and not the Net Profit (after taxes), it puts each company on an even playing field. A company has control over all its expenses, such as whether it buys or leases a building, changes salaries, or gives stock options and pulls back on salaries a bit. Management can also talk to its suppliers, and if it is a big company it might be able to demand reduction in some of the rates it pays to utilities. There is a lot of leeway as to how it does things within the company, but it cannot dictate to the federal government or the state government how much tax it wants to pay. By eliminating the taxes that companies pay, they are put on an even level. By expressing the Pre-tax Profit as a percent (%) of sales, you are able to compare companies in the same industry that are different sizes. In Section 2A of the Stock Selection Guide (SSG) you are looking at what percentage of each dollar a company is able to keep in the form of pre-tax profit or before taxes are paid.

Remember, comparisons need to be done within the same industry, because the pre-tax profit margins vary among the different industries. Industries go through various phases: infancy, growth, maturity, and decline. It does not work to compare companies that are in an industry in a decline phase with companies in an industry in a growth phase. Also, it does not make sense to compare a company in the retail industry where a pre-tax profit margin of 3% is quite good to a company in the biotechnology industry where a pre-tax profit margin might be 40-50%.

Identifying Outliers in Section 2A:
Look for data in 2A that is significantly different from the other data, especially for the most recent five years. Below is an example of an outlier using figures from Williams Company, a natural gas energy company.

 

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Last 5 Years

Trend

Up

Down

A % Pre-tax Profit on Sales

7.1

7.0

11.5

14.1

13.5

15.1

12.1

7.3

4.5

11.4

11.5

Even

Even

The data was eliminated for the year 1999, and some people might even eliminate the data for 1998. If the outlier or anomalous data is in a year that you consider to be irrelevant and the event is non-recurring, you may eliminate that data from the calculation for the most recent five-year average. Remember, if you eliminate the data, find out what happened that year. You might consider phoning the investor relations department of the company to get the information. You can get the company phone number from Value Line under the Business section.

Check whether the percent of Pre-tax Profit on Sales (pre-tax profit margin) has been stable over the entire ten-year period. In the example above, Williams Co. profit margin has declined but is now climbing back up. Check the profit margin performance over the most recent five years. You want profit margins that are increasing and that are performing at or above the industry's average (check www.reuters.com to determine the company and industry pre-tax profit margin). A general rule of thumb is to select companies with profit margins of at least 15%. However, not all industry averages are this high. The company with the highest percentage of pre-tax profit within an industry is probably the best managed company. This may be due to greater efficiency, better marketing ability, patent development, or other factors. If there is a serious downtrend in the profit margins, this would probably disqualify the stock from further consideration.

Summary: Pre-tax Profit on Sales (pre-tax profit margin) is the percentage of revenues remaining after all costs except taxes have been deducted. The higher the margin, the more efficiently the firm is operating. A declining margin may signal aging property or plant and equipment, declining sales volume, declining overall efficiency, or inappropriate policy-making by management.

SECTION B: % EARNED ON EQUITY (EARNINGS PER SHARE ÷ BOOK VALUE PER SHARE)

The Percent (%) Earned on Equity is also referred to as the Return on Equity (ROE). It is a measure of management's efficiency. It is calculated by dividing net income by shareholders' equity. If using Value Line figures, the formula is Earnings per share divided by Book Value per share. It is a measure of how much money a company makes on its equity (its net worth). It is probably the most widely used measure of how well a company is performing for its shareholders, and it can be compared across different industries.

[Note: If there are preferred shares of stock in the company under study, these shares complicate the calculation. The preferred shares must be subtracted from the equation.]

ROE or Percent Earned on Equity measures the company's ability to earn profits on the shareholders equity. Shareholders' equity can include preferred stock, common stock, paid-in capital (capital surplus), retained earnings (earned surplus) and Treasury stock.

Identifying Outliers in Section 2B:

Just as in Section 2A, look for data in 2B that appears to be of a non-recurring nature and out of line with the rest of the data. You may want to eliminate that data. Below is the example of Williams Company for Part B. Remember, if you eliminate the data, find out what happened that year by phoning the investor relations department of the company.

 

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Last 5 Years

Trend

Up

Down

B % Earned on Equity

9.1

9.2

10.1

9.8

9.2

10.3

9.8

7.6

3.1

11.04

9.8

Up

 

The data was eliminated for the year 1999, and some people might even eliminate the data for 1998. If the outlier or anomalous data is in a year that you consider to be irrelevant and the event is non-recurring, you may eliminate that data from the calculation for the most recent five-year average.

Additional Information on ROE:

You want to see the company's Return on Equity increasing over the ten-year period, and you want the return to perform at or above the industry's average. Check the Industry Page in Value Line to determine the industry's average. A general rule of thumb is to select companies with a Return on Equity of at least 15% but ideally closer to 20%. In addition, you want to select companies with an upward or stable trend. A downward trend is a warning sign.

Summary: The higher the Return on Equity, the more efficiently the company is operating and the better the return available to shareholders. The Return on Equity is a function of making good use of assets and careful use of debt. Debt will increase the return on equity, but too much debt may hurt the company if the company cannot meet its interest payments and thereby defaults. See Advanced Procedures for Section 2 of the SSG for more information on this.

ADVANCED PROCEDURES FOR SECTION 2 OF THE SSG

Below are some additional insights on Pre-tax Profit and Return on Equity:

Pre-tax Profit and Return on Equity Are Linked Together:
Parts 2A and 2B of the Stock Selection Guide are linked together. 2A, the Pre-tax Profit on Sales, is buried in the Return on Equity. PTP and ROE should move together. If there is an increase in PTP, then there should be an increase in ROE. If you don't see this happen, then something else is going on. This is not a good sign unless there is an explanation for it. One reason might be that the company has taken on more debt. Another reason might be a merger.

Research and Development (R&D) expenses significantly affect ROE:

If you look at the ROE on companies with a large research and development (R&D) expense such as pharmaceutical companies and high technology companies, many will have high ROE. These companies tend to have an artificially high ROE because of the way accounting rules are structured. Accounting rules have changed over the years. Today accounting rules require companies to declare R&D costs immediately. When, for example, a company like Pfizer wants to develop a drug such as Viagra, it could incur $1 billion in research and development expense for that drug. Before the accounting rules changed, Pfizer would have written-off the R&D expenses in its income statement when it started selling the drug. That would lower profits and that would lead to lower earnings. Now the accounting rules are such that the R&D expenses are declared while the drug is being developed. The sales of Viagra do not reflect the R&D expenses. As a result profits are higher and the earnings are bolstered. The ROE gets bolstered too. Remember, if you are looking at a company with a lot of R&D expense, your ROE tends to be artificially higher than it normally should be. Once you know this about R&D, it is not a bad thing. Any company in this type of industry has to do the same thing. Do not use ROE as an indicator of what growth could be in the future for any company with a lot of R&D expense.

Comparing ROE of different companies in different industries:
ROE can be compared to companies in different industries. ROE is how much money the company earns on its invested capital, and it can be compared against companies in all industries. However, you cannot compare companies in different industries when it comes to Pre-tax Profit Margin (SSG, Section 2A). Each industry varies greatly in its PTP.

How debt affects ROE:
A company can have a high ROE in two ways. One is by having high profit margins or high returns and the other way is by having low equity or too much debt. If your company has a high ROE, look at the percentage of debt to capitalization on the front side of the SSG to get an idea as to whether the high ROE is coming from debt or profit. If a company has a high ROE through debt or leverage, this might be okay if the economy is booming. However, if the economy slows, the company might not be able to meet its payments on its debt, and your company could get into financial difficulty.

Summary:
The best way to generate ROE is by earning the money through sales which will lead to earnings for the company. The second best way to generate ROE is through Asset Turns. See ROE can be divided into three parts for more information. The least desirable way to generate ROE is through leverage or debt. Remember, you cannot compare the Pre-tax Profit % across all industries, but you may compare ROE across all industries.

ROE can be divided into three parts:

The formula for ROE:

ROE = (Net Income/Sales) x (Sales/Assets) x (Assets/Equity)
              Profitability    x    Asset turns    x    Leverage

Profitability is something you see in the SSG, Section 2A when looking at Pre-tax Profit on Sales (PTP). In the ROE formula you are looking at profitability after taxes, not before taxes as you do in Section 2A.

Asset turns help you understand how much of the inventory management is able to sell relative to its asset base or how many times a company turns its assets in a year. This tells how well a company uses its assets in a year.

Leverage is debt. Leverage tells you how much in the way of assets the management of a company has to work with relative to what's actually owned. The higher the debt is, the higher the leverage is.

When looking at these three components of ROE, a larger number is better for profitability and asset turns, but larger is not better for leverage (this means higher debt).

Management decides how it wants to generate its ROE. Is your company one that is profitable or does it turn its assets well or does it have a lot of debt or leverage?

The following is an example showing how companies get Return on Equity. You will be able to see whether the ROE is driven by Sales, Asset Turns, or Debt. The first four columns are the figures needed to do the calculations. The next three columns show the calculations. For example, Profitability in column F is Net Income divided by Sales, or column C divided by column B. The last column shows the ROE for each company.

A

B

C

D

E

F

G

H

I

 

Sales

Net Income

Total Assets

Equity

Profitability Net Inc/Sales
C/B

Asset Turns Sales/Assets
B/D

Leverage Assets/Equity
D/E

ROE
FxGxH

Intel

26273

6068

31471

23578

23.1%

0.83

1.33

25.5

General Electric

100469

9296

355935

38880

9.3%

0.28

9.15

23.8

Nautica

485

56.4

310

251

11.6%

1.56

1.24

22.4

Albertsons

16005

582.6

6235

2810.5

3.6%

2.57

2.22

20.5

Intel at 23.1% is the best company for generating ROE through its profit. It is a very profitable company. Their asset turns are not high due to the nature of its business. If it builds a $1 billion semiconductor facility, this is a huge asset. It will take a long time to turn over this asset. Albertsons at 2.57 has the highest rate of these companies generating asset turns. They are in the grocery business, and they have a very high turnover rate of products on their grocery store shelves. Hence, they turnover their assets at a high rate. General Electric at 9.15 has the largest debt from these companies. Remember, GE has a financial services division and that generates debt.

Return on Equity is important. The most important part of ROE is learning that a company's ROE is not made primarily from debt.

Variation on Calculating ROE:
The BI Method calculates ROE using ending equity. ROE = Earnings per share ÷ Book Value per share (Section 2B of the SSG).

Most analysts calculate ROE using average equity. ROE = Earnings per share ÷ Average Book Value per share. Average Book Value = (Beginning Book Value + Ending Book Value) ÷ 2

The following is an example using AFLAC:

The BI Method using ending year equity:
Ending year Book Value per share = $14.19
Earnings per share = $1.76

ROE = Earnings per share ÷ Book Value per share or 1.76 ÷ 14.19 = 0.124 = 12.4%

The Analyst's Method using average equity:
Beginning Book Value per share = $12.88
Ending Book Value per share = $14.19
Earnings per Share = $1.76
Average Book Value per share = (12.88 + 14.19) ÷ 2 = $13.54

ROE = Earnings per share ÷ Average Book Value per share or 1.76 ÷ 13.54 = 0.130 = 13.0%

There is not a lot of difference between 12.4% and 13%. Both methods are correct. The method using the average equity is more precise. Remember, you are looking for trends. Be consistent with the method you use.

How Value Line Calculates ROE:
Value Line has a calculation for ROE but it is called Shareholders Equity. It is calculated using the average equity formula. That is why the figures for Shareholders Equity from VL do not match the figures for ROE when doing a SSG. Don't be concerned about the differences in individual numbers but instead, focus on the trend. We want the trend to be stable or going up. If it is going down, find out why.

Affects of Mergers and Acquisitions on ROE and data in the SSG:
ROE can fluctuate a lot. Often this is due to a company making an acquisition. When there are mergers, companies restate their figures, especially the earnings. Do not restate the data on your Stock Selection Guide. The reason for this is that there is no way to restate the stock price for the company for those years in which the company restated its figures. Remember, if you change the earnings for a company, but you don't change the price, then your P/E (price/earnings per share) ratios are skewed in your SSG. Your valuation techniques will not work in your SSG if you change your data to reflect the restated figures. This will also affect your Portfolio Evaluation Review Technique (PERT) and your Portfolio Management Guide (PMG) found in Toolkit (BI's software program). If figures are restated on a Value Line report and if you have figures recorded in your Toolkit database, start with the figures on the VL report for the quarter of the update. Do not go back and restate figures in the Toolkit database.

Additional background information on accounting methods which companies use for mergers and acquisitions:
Method 1: This is the accounting method that companies use now. When a company is purchased by another one, the buying company purchases the new company for more than its book value. It seldom happens that a company can be purchased for its book value. Goodwill is the difference between the purchase price of the company and its book value. Book Value is the total tangible assets of a company less liabilities and preferred stock. The purchasing company has to declare the Goodwill and write it off over the next few years. Companies don't like writing off Goodwill, because it is an expense. It is a hit to a company's bottom line and the company's earnings are less.

Method 2: This is the accounting method that many companies previously used, but it is no longer a valid procedure. In the past when a company bought another one, it combined both companies' annual reports and added the assets together. Then the liabilities were added together. These figures became the assets and liabilities for the new company. In this method there is no Goodwill and no write off. That is why many companies preferred this method.

SUSTAINABLE GROWTH RATE

Example using Stryker Corporation (SYK) for Fiscal Year 2007
ROE = 18.3% (from SSG, section 2B)
% of Dividend Payout Ratio = 9.2% (from SSG, section 3G5)

Sustainable Growth Rate = ROE x (1- Dividend Payout Ratio) .183 x (1 - .092 = .908) = .1662 or 16.62%
Note: In this example the .908 or 90.8% is the percentage of earnings that SYK is putting back into the company for its future growth, while it is paying out .092 or 9.2% of its earnings in dividends to its shareholders. The Sustainable growth rate for SYK is .1662 or 16.62%. This means that SYK can grow its future sales at 16.62% without having to incur more debt or issue more stock. SYK can self-fund its growth at this rate. This is no guarantee that sales will grow at this rate. The Sustainable Growth Rate means that it could grow at this rate without having the company incur debt to grow.

If the Company does not pay a dividend, then the Sustainable Growth Rate is the same as ROE (Return on Equity).

MORE HELPFUL BACKGROUND INFORMATION:

When looking at ROE you are getting into the balance sheet of a company. Most of the other information you look at comes from the income statement of the company. The ROE links these two together. The book value comes from the balance sheet. The balance sheet is a listing of all the assets or everything the company owns and a listing of all the liabilities or debt - what the company owes to people. The difference between what a company owns and what it owes is what the company is worth. The worth is known as equity or the company's net worth. If a company has a lot of debt, then the percent of equity of a company will be small. Debt and equity added together give the total worth of the company or the total value of all its assets.

To understand this concept more, it is important to understand the capital structure of a company. If a company needs more money, it has some choices. It can borrow money from lenders or it can issue bonds or it can issue more shares of stock in its company. Shareholders and lenders (such as bondholders) have claims on assets. If the capital structure of a company is 30% debt and 70% equity, then the debt holders have a claim over 30% of the company's assets and the shareholders own 70% of the company's assets free and clear. These are clear from any obligations to anyone else. A simple way to look at return on equity is this way. The return on equity is the return the shareholders get on the assets that they own free and clear.

If you own a company with no debt, 100% of the capital structure is shareholders' equity. Then the Return on Assets and the Return on Equity are the same. To understand this concept, Hugh McManus, former Secretary for the National Investors Association Advisory Board, gave the following example to use on this website.

Imagine that there are five houses in the same neighborhood. Each is identical. Each was built ten years ago and sold for $200,000. They were all destroyed in a flood. FEMA came in and paid each owner $250,000 or $50,000 over what they had paid. Here is the breakdown of how the ROE and ROA looked at the time of the flood.

 

Purchase Price

Owes Bank

Equity

ROE

ROA

Owner 1

$200,000

$150,000

$50,000

100.0%

25%

Owner 2

$200,000

$125,000

$75,000

66.7%

25%

Owner 3

$200,000

$100,000

$100,000

50.0%

25%

Owner 4

$200,000

$50,000

$150,000

33.3%

25%

Owner 5

$200,000

$0

$200,000

25.0%

25%

From this example you can see that Owner 1 with the highest debt level has the greatest ROE. Look at Owner 5, she has no debt, and the ROE and ROA are identical.

Information about Return on Assets (ROA):
If you look at the first two components of the ROE formula, you will understand what Return on Assets (ROA) is. It is (Net Income/Sales) x (Sales/Assets). Sales cancel out each other on both sides of the formula leaving Net Income/Assets, which is ROA.

Many companies use ROA to measure the effectiveness of its managers within its company. A company is able to compare an engineering manager within a firm against a manufacturing manager through ROA. A manager within a firm cannot be compared with another one using ROE, for the manager does not control the borrowing of the company. The manager who runs the manufacturing section of the firm is able to control the profitability of his products, has some control over the sales of his products, and controls the assets that are under his section of the firm. That is why internal managers are measured on Return on Assets.

Credits:

How to Run an Effective Investment Club Meeting, The Model Club Video from BI

Take Stock, Ellis Traub, 2001

Investors Toolkit, 3rd and 4th editions, BI

Stock Selection Guide: The Back Side, cassette tape by Hugh J. D. McManus, from 2000 NAIC Congress and Expo, Philadelphia, PA

Advanced Stock Selection Guide Topics, cassette tape by Robert L. Adams, from 2000 NAIC Congress and Expo, Philadelphia, PA

Dissecting & Exploring Return on Equity (ROE), cassette tape by Gary Ball, from 2000 NAIC Congress and Expo, Philadelphia, PA