Understanding ROE (Part 8)

Today concludes the mini-series on return on equity (ROE) that has also discussed ROA, ROIC, and some case studies.

Probably the most important thing I have learned from writing this is how to deal with unconventional cases like BKNG, SBUX, and DPZ. For starters, look at shareholder equity (total assets – total liabilities)—also known as book value. If negative, then expect quirky ROE numbers like negative numbers or “too-good-to-be-true” triple digits because ROE becomes a [broken] ghost metric. As I have discussed, these are cases where ROA and/or ROIC might be better to study.

With such heavy mention of “shareholder equity” throughout this mini-series, I think it’s worthwhile to spend some time discussing that more common synonym often mentioned in financial writings.

For many different reasons, “book value” is often in quotation marks:

• To distinguish it as a specific accounting term rather than a definitive measure of a company’s true current worth.
• As accounting convention based on historical records that may not align with current market prices [capitalization].
• Because balance sheet reflects costs minus depreciation, which may be much lower than current fair market value.
• To indicate the term is being used in its technical sense as shareholder equity rather than a general estimation of value.
• To signal skepticism or irony regarding the accuracy of the figure (i.e. “scare quotes”).
• To suggest the [cooked] “book value” is inflated or inaccurate if a company’s financial statements are under scrutiny.

Shareholder equity is actual accounting book value, but the quotation marks are a warning label that the official number may hide the economic reality. It’s often just a starting point that may need heavy adjusting because it fails to reflect what a company is truly worth due to standard accounting rules. For example, massive value drivers like brand reputation, proprietary software, and trained workforces are almost always ignored in accounting book value. In practice, book value is often viewed as the bare minimum value [rather than its value as a growing business] if the company were to be shut down immediately.

As a result, analysts often move from the “actual” accounting number to an adjusted book value by revaluing [marking to market] tangible assets (e.g. land) to their current sale price, by cleaning up liabilities by adding off-balance sheet items or potential legal costs that haven’t yet been recognized, and by calculating book value/share subtracting preferred stock to reflect what common shareholders would receive.