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Shareholder™s equity
ROE is a comprehensive indicator of a ¬rm™s performance because it provides an in-
dication of how well managers are employing the funds invested by the ¬rm™s sharehold-
ers to generate returns. On average over long periods, large publicly traded ¬rms in the
U.S. generate ROEs in the range of 11 to 13 percent.
In the long run, the value of the ¬rm™s equity is determined by the relationship be-
tween its ROE and its cost of equity capital.2 That is, those ¬rms that are expected over
the long run to generate ROEs in excess of the cost of equity capital should have market
values in excess of book value, and vice versa. (We will return to this point in more detail
in the chapter on valuation.)
A comparison of ROE with the cost of capital is useful not only for contemplating the
value of the ¬rm but also in considering the path of future pro¬tability. The generation
of consistent supernormal pro¬tability will, absent signi¬cant barriers to entry, attract
competition. For that reason, ROEs tend over time to be driven by competitive forces
toward a “normal” level”the cost of equity capital. Thus, one can think of the cost of
equity capital as establishing a benchmark for the ROE that would be observed in a long-
run competitive equilibrium. Deviations from this level arise for two general reasons.
One is the industry conditions and competitive strategy that cause a ¬rm to generate su-
pernormal (or subnormal) economic pro¬ts, at least over the short run. The second is dis-
tortions due to accounting.
Table 9-1 shows the ROE based on reported earnings for Nordstrom and TJX.

Table 9-1 Return on Equity for Nordstrom and TJX

Nordstrom Nordstrom TJX
Ratio 1998 1997 1998
.........................................................................................................................
Return on equity 15.6% 12.6% 34.5%
.........................................................................................................................
320 Financial Analysis




9-4
Financial Analysis




Nordstrom™s ROE showed a signi¬cant improvement, from 12.6 percent to 15.6 per-
cent, between 1997 and 1998. This indicates that Nordstrom™s strategy of focusing on
pro¬t improvement is beginning to show positive results. Compared to the historical
trends of ROE in the economy, Nordstrom™s 1997 performance can be viewed as being
just about average. Further, its ROE in 1997 is barely adequate to cover reasonable esti-
mates of its equity cost of capital. The three percentage points increase in ROE in 1998
allowed Nordstrom to comfortably exceed both these benchmarks.3 Unfortunately, de-
spite the improvement in 1998, Nordstrom™s performance is still far behind TJX™s ROE
of 34.5 percent. At that performance, TJX was earning excess returns relative to both the
historical trends in ROE in the U.S. economy, as well as its own ROE. TJX™s superior per-
formance relative to Nordstrom is re¬‚ected in the difference in the two companies™ ratio
of market value of equity to its book value. As of June 1999, Nordstrom™s market value
to book value ratio was 3.6, while the same ratio for TJX was 8.6.


Decomposing Profitability: Traditional Approach
A company™s ROE is affected by two factors: how pro¬tably it employs its assets and
how big the ¬rm™s asset base is relative to shareholders™ investment. To understand the
effect of these two factors, ROE can be decomposed into return on assets (ROA) and a
measure of ¬nancial leverage, as follows:
ROA — Financial leverage
=
ROE
Net income Assets
--------------------------- — -------------------------------------------------
=
ROE
Assets Shareholders™ equity
ROA tells us how much pro¬t a company is able to generate for each dollar of assets in-
vested. Financial leverage indicates how many dollars of assets the ¬rm is able to deploy
for each dollar invested by its shareholders.
The return on assets itself can be decomposed as a product of two factors:
Net income Sales
--------------------------- — --------------
-
ROA =
Sales Assets
The ratio of net income to sales is called net pro¬t margin or return on sales (ROS); the
ratio of sales to assets is known as asset turnover. The pro¬t margin ratio indicates how
much the company is able to keep as pro¬ts for each dollar of sales it makes. Asset turn-
over indicates how many sales dollars the ¬rm is able to generate for each dollar of its
assets.
Table 9-2 displays the three drivers of ROE for our retail ¬rms: net pro¬t margins, as-
set turnover, and ¬nancial leverage. Nordstrom™s ROE increased from 12.6 percent to
15.6 percent. This increase is largely driven by an increase in its ¬nancial leverage and,
to a lesser extent, by a small increase in its net pro¬t margin. In fact, its return on equity
in 1998 was hurt by a decline in its asset turnover. TJX™s superior ROE seems to be driven
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Financial Analysis




9-5 Part 2 Business Analysis and Valuation Tools




Table 9-2 Traditional Decomposition of ROE

Nordstrom Nordstrom TJX
Ratio 1998 1997 1998
.........................................................................................................................
Net pro¬t margin (ROS) 4.1% 3.85% 5.3%
— Asset turnover 1.61 1.68 2.89
= Return on assets (ROA) 6.6% 6.5% 15.3%
— Financial leverage 2.37 1.95 2.25
= Return on equity (ROE) 15.6% 12.6% 34.5%
.........................................................................................................................

by higher pro¬t margins and better asset utilization; TJX was able to achieve higher ROE
than Nordstrom even though it has a slightly lower ¬nancial leverage ratio.


Decomposing Profitability: Alternative Approach
Even though the above approach is popularly used to decompose a ¬rm™s ROE, it has
several limitations. In the computation of ROA, the denominator includes the assets
claimed by all providers of capital to the ¬rm, but the numerator includes only the earn-
ings available to equity holders. The assets themselves include both operating assets and
¬nancial assets such as cash and short-term investments. Further, net income includes
income from operating activities, as well as interest income and expense, which are con-
sequences of ¬nancing decisions. Often it is useful to distinguish between these two
sources of performance. Finally, the ¬nancial leverage ratio used above does not recog-
nize the fact that a ¬rm™s cash and short-term investments are in essence “negative debt”
because they can be used to pay down the debt on the company™s balance sheet.4 These
issues are addressed by an alternative approach to decomposing ROE discussed below.5
Before discussing this alternative ROE decomposition approach, we need to de¬ne
some terminology used in this section as well as in the rest of this chapter. This termi-
nology is given in Table 9-3.
We use the terms de¬ned in Table 9-3 to decompose ROE in the following manner:
(Net interest expense after tax)
NOPAT
ROE = ----------------- “ -------------------------------------------------------------------------
-
Equity Equity
Net interest expense after tax Net debt
Net assets
NOPAT
----------------------- — ----------------------- “ --------------------------------------------------------------------- — -------------------
- - -
ROE = -
Net assets Net debt Equity
Equity

----------------------- — «1 + -------------------  “ --------------------------------------------------------------------- — -------------------
Net interest expense after tax Net debt
Net debt
NOPAT
- - -
ROE = -
 Equity 
Net assets Net debt Equity
Operating ROA + ( Operating ROA “ Effective interest rate after tax )
ROE =
ROEMY = — Net financial leverage
ROE = Operating ROA + Spread — Net financial leverage
322 Financial Analysis




9-6
Financial Analysis




Table 9-3 Definitions of Accounting Items Used in Ratio Analysis

Item De¬nition
.........................................................................................................................
(Interest expense “ Interest income) — (1 “ Tax rate)
Net interest expense after tax
Net operating pro¬t after taxes
(NOPAT) Net income + Net interest expense after tax
Operating working capital (Current assets “ Cash and marketable securities) “
(Current liabilities “ Short-term debt and current
portion of long-term debt)
Net long-term assets Total long-term assets “ Non-interest-bearing long-term
liabilities
Net debt Total interest bearing liabilities “ Cash and marketable
securities
Net assets Operating working capital + Net long-term assets
Net capital Net debt + Shareholders™ equity
.........................................................................................................................


Operating ROA is a measure of how pro¬tably a company is able to deploy its operating
assets to generate operating pro¬ts. This would be a company™s ROE if it were ¬nanced
with all equity. Spread is the incremental economic effect from introducing debt into the
capital structure. This economic effect of borrowing is positive as long as the return on
operating assets is greater than the cost of borrowing. Firms that do not earn adequate
operating returns to pay for interest cost reduce their ROE by borrowing. Both the posi-
tive and negative effect is magni¬ed by the extent to which a ¬rm borrows relative to its
equity base. The ratio of net debt to equity provides a measure of this net ¬nancial lever-
age. A ¬rm™s spread times its net ¬nancial leverage, therefore, provides a measure of the
¬nancial leverage gain to the shareholders.
Operating ROA can be further decomposed into NOPAT margin and operating asset
turnover as follows:
Sales
NOPAT
----------------- — -----------------------
-
Operating ROA =
Sales Net assets
NOPAT margin is a measure of how pro¬table a company™s sales are from an operating
perspective. Operating asset turnover measures the extent to which a company is able to
use its operating assets to generate sales.
Table 9-4 presents the decomposition of ROE for Nordstrom and TJX. The ratios in
this table show that there is a signi¬cant difference between Nordstrom™s ROA and
operating ROA. In 1998, for example, Nordstrom™s ROA was 6.6 percent, and its operat-
ing ROA was 11.7 percent. This difference in ROA and operating ROA is even more
remarkable for TJX: its ROA in 1998 was 15.3 percent whereas the operating ROA was
43 percent. Because TJX had a large amount of non-interest-bearing liabilities and short-
term investments, its operating ROA is dramatically larger than its ROA. This shows that,
for at least some ¬rms, it is important to adjust the simple ROA to take into account
interest expense, interest income, and ¬nancial assets.
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9-7 Part 2 Business Analysis and Valuation Tools




Table 9-4 Distinguishing Operating and Financing Components in ROE
Decomposition
Nordstrom Nordstrom TJX
Ratio 1998 1997 1998
.........................................................................................................................
Net operating pro¬t margin 4.7% 4.3% 5.3%
— Net operating asset turnover 2.49 2.27 8.11
= Operating ROA 11.7% 9.8% 43.0%
Spread 7.3% 6.4% 42.9%
— Net ¬nancial leverage 0.54 0.45 (0.20)
= Financial leverage gain 3.9% 2.8% (8.5)%
ROE = Operating ROA + Financial
leverage gain 15.6% 12.6% 34.5%
.........................................................................................................................


The appropriate benchmark for evaluating operating ROA is the weighted average
cost of debt and equity capital, or WACC. In the long run, the value of the ¬rm™s assets
is determined by where operating ROA stands relative to this norm. Moreover, over the
long run and absent some barrier to competitive forces, operating ROA will tend to be
pushed towards the weighted average cost of capital. Since the WACC is lower than the
cost of equity capital, operating ROA tends to be pushed to a level lower than that to
which ROE tends. The average operating ROA for large ¬rms in the U.S., over long
periods of time, is in the range of 9 to 11 percent. Nordstrom™s operating ROA in 1997
and 1998 is in this range, indicating that its operating performance is about average. At
43 percent, TJX™s operating ROA is far larger than Nordstrom™s and also the U.S. indus-
trial average and any reasonable estimates of TJX™s weighted average cost of capital.
This dramatic superior operating performance of TJX would have been obscured by us-
ing the simple ROA measure.6
TJX dominates Nordstrom in terms of both operating drivers of ROE”it has a better
NOPAT margin and a dramatically higher operating asset turnover. TJX™s higher operat-
ing asset turnover is primarily a result of its strategy of renting its stores, unlike Nord-
strom, which owns many of its stores. What is surprising is TJX™s higher NOPAT margin,
which suggests that Nordstrom is unable to price its merchandise high enough to recoup
the cost of its high service strategy.
Nordstrom is able to create shareholder value through its ¬nancing strategy. In 1997
the spread between Nordstrom™s operating ROA and its after-tax interest cost was
6.4 percent; its net debt as a percent of its equity was 45 percent. Both these factors con-
tributed to a net increment of 2.8 percent to its ROE. Thus, while the Nordstrom™s oper-
ating ROA in 1997 was 9.8 percent, its ROE was 12.6 percent. In 1998 Nordstrom™s
spread increased to 7.3 percent, its net ¬nancial leverage went up to 0.54, leading to a
3.9 percent net increment to ROE due to its debt policy. With an operating ROA of 11.7

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( 208 .)



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