Question

1. A firm has positive free cash flow and a net dividend to shareholders that is less than free cash flow. What must it do with the surplus of the free cash flow over the dividend?                                                                                                                                                
2. Explain why it is common that firms with higher return on net operating assets (RONA) also have negative free cash flows. Also, explain why such firms tend to have above-average forward P/E ratio.                                                                                                        
3. P/B ratio is often said to indicate a growth stock. Explain under which situation a firm with high P/B can be a zero growth firm.                              
4. Explain why a firm can have a low trailing P/E ratio but have a high expected earnings growth rate in the future.                                                                  
5. Under what conditions would a firm’s return on common equity (ROCE) be equal to its return on net operating assets (RNOA)?

Answer 1

A firm has positive free cash flow and a net dividend to shareholders that is less than free cash flow. What must it do with the surplus of the free cash flow over the dividend?    

Free cash flow (FCF) represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital from the balance sheet.

Interest payments are excluded from the generally accepted definition of free cash flow. Investment bankers and analysts who need to evaluate a company’s expected performance with different capital structures will use variations of free cash flow like free cash flow for the firm and free cash flow to equity, which are adjusted for interest payments and borrowings.

Similar to sales and earnings, free cash flow is often evaluated on a per share basis to evaluate the effect of dilution.

Free cash flow (FCF) is the cash flow available for the company to repay creditors or pay dividends and interest to investors. Some investors prefer FCF or FCF per share over earnings or earnings per share as a measure of profitability because it removes non-cash items from the income statement. However, because FCF accounts for investments in property, plant, and equipment, it can be lumpy and uneven over time.

Benefits of Free Cash Flow (FCF)

Because FCF accounts for changes in working capital, it can provide important insights into the value of a company and the health of its fundamental trends. For example, a decrease in accounts payable (outflow) could mean that vendors are requiring faster payment. A decrease in accounts receivable (inflow) could mean the company is collecting cash from its customers quicker. An increase in inventory (outflow) could indicate a building stockpile of unsold products. Including working capital in a measure of profitability provides an insight that is missing from the income statement.

For example, assume that a company had made $50,000,000 per year in net income each year for the last decade. On the surface, that seems stable but what if FCF has been dropping over the last two years as inventories were rising (outflow), customers started to delay payments (outflow) and vendors began demanding faster payments (outflow) from the firm? In this situation, FCF would reveal a serious financial weakness that wouldn’t have been apparent from an examination of the income statement alone.

FCF is also helpful as the starting place for potential shareholders or lenders to evaluate how likely the company will be able to pay their expected dividends or interest. If the company’s debt payments are deducted from FCF (Free Cash Flow to the Firm), a lender would have a better idea of the quality of cash flows available for additional borrowings. Similarly, shareholders can use FCF minus interest payments to think about the expected stability of future dividend payments.

Limitations of Free Cash Flow (FCF)

Imagine a company has earnings before depreciation, amortization, interest, and taxes (EBITDA) of $1,000,000 in a given year. Also, assume that this company has had no changes in working capital (current assets – current liabilities) but they bought new equipment worth $800,000 at the end of the year. The expense of the new equipment will be spread out over time via depreciation on the income statement, which evens out the impact on earnings.

However, because FCF accounts for the cash spent on new equipment in the current year, the company will report $200,000 FCF ($1,000,000 EBITDA - $800,000 Equipment) on $1,000,000 of EBITDA that year. If we assume that everything else remains the same and there are no further equipment purchases, EBITDA and FCF will be equal again the next year. In this situation, an investor will have to determine why FCF dipped so quickly one year only to return to previous levels, and if that change is likely to continue.

Additionally, understanding the depreciation method being used will garner further insights. For example, net income and FCF will differ based on the amount of depreciation taken per year of the asset's useful life. If the asset is being depreciated using the book depreciation method, over a useful life of 10 years, then net income will be lower than FCF by $80,000 ($800,000 / 10 years) for each year until the asset is fully depreciated. Alternatively, if the asset is being depreciated using the tax depreciation method, the asset will be fully depreciated in the year it was purchased, resulting in net income equaling FCF in subsequent years.

Explain why it is common that firms with higher return on net operating assets (RONA) also have negative free cash flows. Also, explain why such firms tend to have above-average forward P/E ratio.

Return on net assets (RONA) is a measure of financial performance calculated as net profit divided by the sum of fixed assets and net working capital. Net profit is also called net income.

The RONA ratio shows how well a company and its management are deploying assets in economically valuable ways, and a high ratio result indicates that management is squeezing more earnings out of each dollar invested in assets. RONA is also used to assess how well a company is performing compared to others in its industry.

The three components of RONA are net income, fixed assets, and networking capital. Net income is found in the income statement and is calculated as revenue minus expenses associated with making or selling the company's products, operating expenses such as management salaries and utilities, interest expenses associated with debt, and all other expenses.

Fixed assets are tangible property used in production, such as real estate and machinery, and do not include goodwill or other intangible assets carried on the balance sheet. Networking capital is calculated by subtracting the company's current liabilities from its current assets. It is important to note that long-term liabilities are not part of working capital and are not subtracted in the denominator when calculating working capital for the return on net assets ratio.

At times, analysts make a few adjustments to the ratio formula inputs to smooth or normalize the results, especially when comparing to other companies. For example, consider that the fixed assets balance could be affected by certain types of accelerated depreciation, where up to 40% of the value of an asset could be eliminated in its first full year of deployment.

Additionally, any significant events that resulted in either a large loss or unusual income should be adjusted out of net income, especially if these are one-time events. Intangible assets such as goodwill are another item that analysts sometimes remove from the calculation, since it is often simply derived from an acquisition, rather than being an asset purchased for use in producing goods, such as a new piece of equipment.

What Does RONA Tell You?

The return on net assets (RONA) ratio compares a firm's net income with its assets and helps investors to determine how well the company is generating profit from its assets. The higher a firm's earnings relative to its assets, the more effectively the company is deploying those assets. RONA is an especially important metric for capital intensive companies, which have fixed assets as their major asset component.

In the capital-intensive manufacturing sector, RONA can also be calculated as:

\text{Return On Net Assets}=\frac{\text{Plant Revenue } - \text{ Costs}}{\text{Net Assets}}Return On Net Assets=Net AssetsPlant Revenue − Costs​

Interpreting Return on Net Assets

The higher the return on net assets, the better the profit performance of the company. A higher RONA means the company is using its assets and working capital efficiently and effectively, although no single calculation tells the whole story of a company's performance. Return on net assets is just one of many ratios used to evaluate a company's financial health.

If the purpose of performing the calculation is to generate a longer-term perspective of the company's ability to create value, extraordinary expenses may be added back into the net income figure. For example, if a company had a net income of $10 million but incurred an extraordinary expense of $1 million, the net income figure could be adjusted upward to $11 million. This adjustment provides an indication of the return on net assets the company could expect in the following year if it does not have to incur any further extraordinary expenses.

Example of How to Use RONA

Assume a company has revenue of $1 billion and total expenses including taxes of $800 million, giving it a net income of $200 million. The company has current assets of $400 million and current liabilities of $200 million, giving it net working capital of $200 million.

Further, the company's fixed assets amount to $800 million. Adding fixed assets to networking capital yields $1 billion in the denominator when calculating RONA. Dividing the net income of $200 million by $1 billion yields a return on net assets of 20% for the company.

                                                                                                       

P/B ratio is often said to indicate a growth stock. Explain under which situation a firm with high P/B can be a zero growth firm. Explain why a firm can have a low trailing P/E ratio but have a high expected earnings growth rate in the future.                                                             

Companies use the price-to-book ratio (P/B ratio) to compare a firm's market capitalization to its book value. It's calculated by dividing the company's stock price per share by its book value per share (BVPS). An asset's book value is equal to its carrying value on the balance sheet, and companies calculate it netting the asset against its accumulated depreciation.

Book value is also the tangible net asset value of a company calculated as total assets minus intangible assets (patents, goodwill) and liabilities. For the initial outlay of an investment, book value may be net or gross of expenses, such as trading costs, sales taxes, and service charges. Some people may know this ratio by its less common name, price-equity ratio.

The P/B ratio reflects the value that market participants attach to a company's equity relative to the book value of its equity. A stock's market value is a forward-looking metric that reflects a company's future cash flows. The book value of equity is an accounting measure based on the historic cost principle and reflects past issuances of equity, augmented by any profits or losses, and reduced by dividends and share buybacks.

The price-to-book ratio compares a company's market value to its book value. The market value of a company is its share price multiplied by the number of outstanding shares. The book value is the net assets of a company.

In other words, if a company liquidated all of its assets and paid off all its debt, the value remaining would be the company's book value. P/B ratio provides a valuable reality check for investors seeking growth at a reasonable price and is often looked at in conjunction with return on equity (ROE), a reliable growth indicator. Large discrepancies between the P/B ratio and ROE often send up a red flag on companies. Overvalued growth stocks frequently show a combination of low ROE and high P/B ratios. If a company's ROE is growing, its P/B ratio should also be growing.

P/B Ratios and Public Companies

It is difficult to pinpoint a specific numeric value of a "good" price-to-book (P/B) ratio when determining if a stock is undervalued and therefore a good investment. Ratio analysis can vary by industry. A good P/B ratio for one industry might be a poor ratio for another.

It's helpful to identify some general parameters or a range for P/B value, and then consider various other factors and valuation measures that more accurately interpret the P/B value and forecast a company's potential for growth.

The P/B ratio has been favored by value investors for decades and is widely used by market analysts. Traditionally, any value under 1.0 is considered a good P/B for value investors, indicating a potentially undervalued stock. However, value investors may often consider stocks with a P/B value under 3.0 as their benchmark.

Equity Market Value vs. Book Value

Due to accounting conventions on the treatment of certain costs, the market value of equity is typically higher than the book value of a company, resulting in a P/B ratio above 1. Under certain circumstances of financial distress, bankruptcy or expected plunges in earnings power, a company's P/B ratio can dive below a value of 1.

Because accounting principles do not recognize intangible assets such as the brand value, unless the company derived them through acquisitions, companies expense all costs associated with creating intangible assets immediately.

For example, companies must expense research and most development costs, reducing a company's book value. However, these R&D outlays can create unique production processes for a company or result in new patents that can bring royalty revenues going forward. While accounting principles favor a conservative approach in capitalizing costs, market participants may raise the stock price because of such R&D efforts, resulting in wide differences between the market and book values of equity.

Example of How to Use the P/B Ratio

Assume that a company has $100 million in assets on the balance sheet and $75 million in liabilities. The book value of that company would be calculated simply as $25 million ($100M - $75M). If there are 10 million shares outstanding, each share would represent $2.50 of book value. If the share price is $5, then the P/B ratio would be 2x (5 / 2.50). This illustrates that the market price is valued at twice its book value.

The Difference Between P/B Ratio and Price-to-Tangible-Book Ratio

Closely related to the P/B ratio is the price to tangible book value ratio (PTBV). The latter is a valuation ratio expressing the price of a security compared to its hard, or tangible, book value as reported in the company's balance sheet. The tangible book value number is equal to the company's total book value less than the value of any intangible assets.

Intangible assets can be items such as patents, intellectual property, and goodwill. This may be a more useful measure of valuation when the market is valuing something like a patent in different ways or if it is difficult to put a value on such an intangible asset in the first place.

Limitations of using P/B Ratio

Investors find the P/B ratio useful because the book value of equity provides a relatively stable and intuitive metric they can easily compare to the market price. The P/B ratio can also be used for firms with positive book values and negative earnings since negative earnings render price-to-earnings ratios useless, and there are fewer companies with negative book values than companies with negative earnings.

However, when accounting standards applied by firms vary, P/B ratios may not be comparable, especially for companies from different countries. Additionally, P/B ratios can be less useful for service and information technology companies with little tangible assets on their balance sheets. Finally, the book value can become negative because of a long series of negative earnings, making the P/B ratio useless for relative valuation.

Other potential problems in using the P/B ratio stem from the fact that any number of scenarios, such as recent acquisitions, recent write-offs, or share buybacks, can distort the book value figure in the equation. In searching for undervalued stocks, investors should consider multiple valuation measures to complement the P/B ratio.              

Under what conditions would a firm’s return on common equity (ROCE) be equal to its return on net operating assets (RNOA)?

Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders' equity. Because shareholders' equity is equal to a company’s assets minus its debt, ROE is considered the return on net assets. ROE is considered a measure of how effectively management is using a company’s assets to create profits.

ROE is expressed as a percentage and can be calculated for any company if net income and equity are both positive numbers. Net income is calculated before dividends paid to common shareholders and after dividends to preferred shareholders and interest to lenders.

\begin{aligned} &\text{Return on Equity} = \dfrac{\text{Net Income}}{\text{Average Shareholders' Equity}}\\ \end{aligned}​Return on Equity=Average Shareholders’ EquityNet Income​​

Net income is the amount of income, net of expense, and taxes that a company generates for a given period. Average shareholders' equity is calculated by adding equity at the beginning of the period. The beginning and end of the period should coincide with the period during which the net income is earned.

Net income over the last full fiscal year, or trailing 12 months, is found on the income statement—a sum of financial activity over that period. Shareholders' equity comes from the balance sheet—a running balance of a company’s entire history of changes in assets and liabilities.

It is considered best practice to calculate ROE based on average equity over a period because of the mismatch between the income statement and the balance sheet.

What Does ROE Tell You?

Whether ROE is deemed good or bad will depend on what is normal among a stock’s peers. For example, utilities have many assets and debt on the balance sheet compared to a relatively small amount of net income. A normal ROE in the utility sector could be 10% or less.1 A technology or retail firm with smaller balance sheet accounts relative to net income may have normal ROE levels of 18% or more.2

A good rule of thumb is to target an ROE that is equal to or just above the average for the peer group. For example, assume a company, TechCo, has maintained a steady ROE of 18% over the last few years compared to the average of its peers, which was 15%. An investor could conclude that TechCo’s management is above average at using the company’s assets to create profits. Relatively high or low ROE ratios will vary significantly from one industry group or sector to another. When used to evaluate one company to another similar company, the comparison will be more meaningful. A common shortcut for investors is to consider a return on equity near the long-term average of the S&P 500 (14%) as an acceptable ratio and anything less than 10% as poor.

Using ROE to Estimate Growth Rates

Sustainable growth rates and dividend growth rates can be estimated using ROE, assuming that the ratio is roughly in line or just above its peer group average. Although there may be some challenges, ROE can be a good starting place for developing future estimates of a stock’s growth rate and the growth rate of its dividends. These two calculations are functions of each other and can be used to make an easier comparison between similar companies.

To estimate a company’s future growth rate, multiply the ROE by the company’s retention ratio. The retention ratio is the percentage of net income that is retained or reinvested by the company to fund future growth.

ROE and a Sustainable Growth Rate

Assume that there are two companies with an identical ROE and net income, but different retention ratios. Company A has an ROE of 15% and returns 30% of its net income to shareholders in a dividend, which means company A retains 70% of its net income. Business B also has an ROE of 15% but returns only 10% of its net income to shareholders for a retention ratio of 90%.

For company A, the growth rate is 10.5%, or ROE times the retention ratio, which is 15% times 70%. Business B's growth rate is 13.5%, or 15% times 90%.

This analysis is referred to as the sustainable growth rate model. Investors can use this model to make estimates about the future and to identify stocks that may be risky because they are running ahead of their sustainable growth ability. A stock that is growing slower than its sustainable rate could be undervalued, or the market may be discounting risky signs from the company. In either case, a growth rate that is far above or below the sustainable rate warrants additional investigation.

This comparison seems to make business B more attractive than company A, but it ignores the advantages of a higher dividend rate that may be favored by some investors. We can modify the calculation to estimate the stock’s dividend growth rate, which may be more important to income investors.

Estimating the Dividend Growth Rate

Continuing with our example from above, the dividend growth rate can be estimated by multiplying ROE by the payout ratio. The payout ratio is the percentage of net income that is returned to common shareholders through dividends. This formula gives us a sustainable dividend growth rate, which favors company A.

The company A dividend growth rate is 4.5%, or ROE times the payout ratio, which is 15% times 30%. Business B's dividend growth rate is 1.5%, or 15% times 10%. A stock that is growing its dividend far above or below the sustainable dividend growth rate may indicate risks that should be investigated.

Using ROE to Identify Problems

It is reasonable to wonder why an average or slightly above average ROE is good rather than an ROE that is double, triple, or even higher the average of their peer group. Aren’t stocks with a very high ROE a better value?

Sometimes an extremely high ROE is a good thing if net income is extremely large compared to equity because a company’s performance is so strong. However, an extremely high ROE is often due to a small equity account compared to net income, which indicates risk.

Inconsistent Profits

The first potential issue with a high ROE could be inconsistent profits. Imagine a company, LossCo, that has been unprofitable for several years. Each year’s losses are recorded on the balance sheet in the equity portion as a “retained loss.” The losses are a negative value and reduce shareholder equity. Assume that LossCo has had a windfall in the most recent year and has returned to profitability. The denominator in the ROE calculation is now very small after many years of losses, which makes its ROE misleadingly high.

Excess Debt

A second issue that could cause a high ROE is excess debt. If a company has been borrowing aggressively, it can increase ROE because equity is equal to assets minus debt. The more debt a company has, the lower equity can fall. A common scenario is when a company borrows large amounts of debt to buy back its own stock. This can inflate earnings per share (EPS), but it does not affect actual performance or growth rates.

Negative Net Income

Finally, negative net income and negative shareholder equity can create an artificially high ROE. However, if a company has a net loss or negative shareholders’ equity, ROE should not be calculated.

If shareholders’ equity is negative, the most common issue is excessive debt or inconsistent profitability. However, there are exceptions to that rule for companies that are profitable and have been using cash flow to buy back their own shares. For many companies, this is an alternative to paying dividends, and it can eventually reduce equity (buybacks are subtracted from equity) enough to turn the calculation negative.

In all cases, negative or extremely high ROE levels should be considered a warning sign worth investigating. In rare cases, a negative ROE ratio could be due to a cash flow supported share buyback program and excellent management, but this is the less likely outcome. In any case, a company with a negative ROE cannot be evaluated against other stocks with positive ROE ratios.

Limitations of ROE

A high ROE might not always be positive. An outsized ROE can be indicative of a number of issues—such as inconsistent profits or excessive debt. Also, a negative ROE due to the company having a net loss or negative shareholders’ equity cannot be used to analyze the company, nor can it be used to compare against companies with a positive ROE.

ROE vs. Return on Invested Capital

While return on equity looks at how much profit a company can generate relative to shareholders’ equity, return on invested capital (ROIC) takes that calculation a couple of steps further.

The purpose of ROIC is to figure out the amount of money after dividends a company makes based on all its sources of capital, which includes shareholders equity and debt. ROE looks at how well a company uses shareholder equity while ROIC is meant to determine how well a company uses all its available capital to make money.