Equity Growth Rate

Equity growth rate for any company is also known as the book value growth rate.  Equity is what is left over when liabilities are subtracted from assets on a company’s balance sheet.  Equity represents what is left over if a company is liquidated and ceases to exist.  The equity growth rate is the percentage that equity per outstanding share of stock (or book value per share) has grown over the last year.  Equity grows when a business accumulates surplus profits.  Think about it – many profitable businesses have to use their earnings to fund their growth, either by building new stores, replacing old or worn out capital equipment, etc.  Businesses that accumulate excess profits while still growing are special indeed!  We use equity growth rate to find these great businesses.

How to Calculate Equity Growth Rate

Learning how to calculate equity growth rate is a great companion for the other skill you learned for finding great investments when you learned how to calculate ROIC.  Equity growth rate is calculated by dividing this years book value per share by last years book value per share, the subtracting 1:

Equity Growth Rate = BVPS(today)/BVPS(last year) – 1

Equity growth rate is represented as a percentage.  Make sure you adjust for dividend distributions (if any) to get an accurate view of equity growth rate.

What to look for in equity growth rate

Consistent equity growth of greater than 10% over 5 to 10 years is what a great company should have.  If you see some anomallies in the historical equity growth rates, take the time to understand why those divergences from the trend occurred (both up or down divergences).  Value investing looks for companies with good equity growth rates that may be temporarily under priced.  Comparing the equity growth rate between companies in the same industry is a good way to rate which ones should be considered as an investment.

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Business revenue growth is a very important fundamental analysis indicator used by investors for picking good value stocks.  To start with lets go over the difference between business revenue and total revenue.  Business revenue is income, or sales, that comes from the primary activities for a given company, whether it is organized as a corporation, partnership, sole-proprietorship, etc., doesn’t matter, business revenue is the same across all types of companies. 

Business revenue does not include other types of revenue that may be included on a given comany’s balance sheet like incidental or non-operating revenue.  Some examples of the types of revenue streams will help you see the difference between non-operating revenue and business revenue.  One example would be incidental revenue earned on a deposit in a demand bank account – this type of revenue is not associated with business revenue generated by the primary activity of the company.  Another type of non-operating revenue that needs to be filtered out of the total revenue number might be from a manufacturing company owning or leasing a building, and sub-leasing a portion of the building that it is not using to another company – again, this is not business revenue, but would show up in the top line number on an income statement.

The focus of your value stock picking should be on business revenue growth, also known as net sales growth.  Examples of business revenue would include a manufacturing company or a bakery selling goods, or an accounting firm or a consulting firm selling services.

Business revenue growth is calculated by dividing this periods (typically quarterly or annual) net sales by last periods net sales and subtracting 1.  This gives you the percent growth, or reduction, in business revenue.  Above average business revenue growth combined with the company efficiency you can find by learning how to calculate ROIC, is a great way to filter stock candidates down to a manageable list.

Good value stocks have business revenue growth that is greater than the company’s peers in it’s industry.  It should have consistent multi-year growth, if there is an anomally in the annual growth rate, make sure you understand why – it could be anything from a recession that took out all company’s growth, to the introduction of a game changing technology that the stock will have a hard time recovering from.

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What is Return On Equity?

Return on equity is a popular fundamental analysis technique to measure how efficiently a company uses it’s shareholders’ investment to produce eanings.  The formula to calculate Return On Equity (ROE) is straightforward:

Return on Equity (ROE) = Net Income / Shareholder equity

Obviously this is a much simpler formula than how to calculate ROIC (return on invested capital).  Some investors would answer the “What is Return On Equity?” question by stating that return on equity is an easy and readily available way to compare different companies profitability.  A company with a high return on equity is more likely to be capable of generating cash organically (internally). For the most part, the higher a company’s return on equity compared to its industry, the better.  You need to look at ROE relative to the industry the company your evaluating is in, because not all high ROE companies make good investments.  For example, companies that require little very little assets, like consultants, will have high ROE’s relative to capital intensive companies.

So, hopefully this helped you understand what is return on equity.

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Lets look at how to calculate ROIC (Return on Invested Capital).  I make no secret that ROIC is one of my favorite value stock investing tools.   Learning how to calculate ROIC is relatively easy, and will require you to look at a company’s financial reports to get the numbers you need to calculate ROIC.

The formula for how to calculate ROIC is:

ROIC = ((Net Operating Profit – Income Tax) / (long term debt + equity))

 ROIC calculations look like they have a lot going on, but I’ll now show you how easy it is to get everything so you can calculate ROIC.

Lets use Walgreens in 2007 as an example of how to calculate ROIC, click here for the data you’ll need to follow along with this ROIC example.

From the Income statement, the numerator in the ROIC calculation (Net Operating Profit - Taxes) is 2041.3, you can find this about half way down the page.

The next step to learn how to calculate ROIC is to determine the denominator, so we’ll look at the Balance Sheet tab on the above Walgreens data, and find equity is 11,104.3, and long term debt (+ other liabilities) is 1284.8, which means the ROIC denominator is 12389.1.

So ROIC is 2041.3/12389.1 = 15.5%

Now you know how to calculate ROIC.

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ROIC, or  Return On Invested Capital, is one of my favorite value investing indicators for trying to forecast the financial performance of a company’s stock.  If you think about earnings growth at a high level, most companies have to pay a price to achieve earnings growth – by issuing stock, selling long term bonds (debt), investing in assets, and/or investing in working capital.  ROIC is a superior way to measure this cost to achieve growth, and to compare one company’s financial performance to another company’s, or for that matter, to the performance of an industry group as a whole.  In a nutshell, ROIC is a way of determining the amount of cash earnings a company produces for every dollar invested, and is a primary tool for value investing, along with equity growth rate, earnings yield, and free cash flow growth.

You may already be familiar with one of the cousins of ROIC – Return on Equity (ROE).  ROE, which divides net income by the average shareholder equity over the time period being examined, is also a good measure of a company’s financial performance, and a favorite stock value indicator among value investors.  Click here if you want to learn more about what is Return On Equity.  The downside of ROE is that it does not take into account certain balance sheet liabilities that are being used to power a company’s growth, thus ROE may overstate the company’s economic efficiency.  ROIC corrects this issue, which is why I like it better than ROE.

ROIC is a good way to measure the quality of earnings growth, and is calculated with Net Operating Profit After Taxes (NOPAT) to focus on that earnings quality.  Lets use an example:  Company ABC sells a popular line of widgets, and earned $20 million last year.  This year, they decide to expand, and take on $20 billion in debt to finance that growth.  They are successful, and their earning double to $40 million.  Investors focusing on earnings growth are ecstatic – the company doubled it’s yearly earnings.  ROIC investors, however, are probably running for the exits, because they see that while the company doubled it’s earnings, the debt the company took on to finance that earnings growth only yielded a 1% return ($20 million divided by $20 billion), which is a very inefficient use of dollars invested in the company.  ROIC, unlike ROE or earnings growth, will highlight that inefficient use of dollars.  Investors looking for value stocks should look for high returns on invested dollars, as represented by ROIC, in addition to other key fundamental measures like business revenue growth.

Next up we will look at how to calculate ROIC.

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