Chapter 11
Clean Surplus ROE—the Only Comparable Efficiency Ratio
Developing the Tools to Determine the Probability of Predictability
You are now aware of a very straightforward method for calculating a return on equity that is truly common to all stocks. We are calculating both the return (net income) and the owners’ equity the same way for each individual stock. We are comparing apples to apples and peaches to peaches.
Let’s review by thinking once again of the bank account examples shown in Table 11.1. The account of Bank A is earning more money in year five ($14.60) because it has a higher equity (asset) base ($146). How did Bank A accumulate a higher equity (asset base) than Bank B when both began year one with the same amount of equity? Because Bank A earned a greater return on its asset base. Since it earned a higher return and reinvested all the interest back into the account, Bank A was thus able to retain more dollars than Bank B.
Table 11.1 Bank A and Bank B—Beginning with $100
| Bank A | Bank B | |||||
| Year | Equity | Interest | ROE | Equity | Interest | ROE |
| 5 | $146.00 | $14.60 | 10.00% | $142.45 | $11.40 | 8.00% |
| 4 | $133.00 | $13.30 | 10.00% | $131.29 | $11.00 | 8.50% |
| 3 | $121.00 | $12.10 | 10.00% | $120.45 | $10.85 | 9.00% |
| 2 | $110.00 | $11.00 | 10.00% | $110.00 | $10.45 | 9.50% |
| 1 | $100.00 | $10.00 | 10.00% | $100.00 | $10.00 | 10.00% |
Now here’s the ultimate, most important, mind-shattering, earthshaking saber-rattling question in the entire world of investing. If you had the opportunity to buy the assets of the account in Bank A or the assets of the account in Bank B, which account would you be required to pay more for?
Now you are beginning to understand why some stocks sell for more than other stocks. They are earning more. Why are they earning more? Because they are generating a higher return on a larger and faster increasing asset base through the reinvestment of their earnings. And if they have done this consistently in the past over a long period of time, we might logically expect them to continue to do so in the future.
My stocks are worth more than your stocks because I pick stocks with a high and very consistent ROE (Clean Surplus Accounting), and my stocks retain more profits and thus build the asset base faster than your stocks. The larger the asset base, the more products it can produce. The more products, the more sales. The more the sales, the more profits. The greater the profits, the higher the value of the company. Period!
If I must compare one company with another as to greater operating efficiency, I have a very simple and practical method to do so. And now, so do you.
Clean Surplus
We are about to embark on real-life examples with both General Electric and General Motors. Since the time I gave these examples in the first edition of this book, General Electric went through a very tough period, and General Motors went bankrupt. We will revisit both these companies in Chapters 13 and 14 where we will bring these companies up to date. We will show you when and why we sold General Electric, and we will tell you why we never would think of buying General Motors. Please notice the dates on these stocks as they are not up to date in this chapter. They will be brought up to date later.
OK everybody, ready to analyze real stocks? Let’s begin with General Electric shown in Table 11.2. We begin our analysis with book value from January of 1986. Why 1986? 1986 just happened to be the first year for which I had data, and we would like to have at least 10 years of data so we can see if the stock exhibits a pattern of consistency.
Table 11.2 General Electric (GE)
| Year | Owners’ Equity | Net Income | Dividends Paid | Retained Earnings | Return on Equity |
| 2002 | $7.16 | $1.65 | $0.72 | $0.93 | 23.05% |
| 2001 | $6.39 | $1.41 | $0.64 | $0.77 | 22.08% |
| 2000 | $5.67 | $1.29 | $0.57 | $0.72 | 22.76% |
| 1999 | $5.09 | $1.07 | $0.49 | $0.58 | 21.03% |
| 1998 | $4.58 | $0.93 | $0.42 | $0.51 | 20.32% |
| 1997 | $4.11 | $0.83 | $0.36 | $0.47 | 20.21% |
| 1996 | $3.70 | $0.73 | $0.32 | $0.41 | 19.75% |
| 1995 | $3.33 | $0.65 | $0.28 | $0.37 | 19.54% |
| 1994 | $3.00 | $0.58 | $0.25 | $0.33 | 19.35% |
| 1993 | $2.71 | $0.51 | $0.22 | $0.29 | 18.84% |
| 1992 | $2.48 | $0.42 | $0.19 | $0.23 | 16.96% |
| 1991 | $2.22 | $0.43 | $0.17 | $0.26 | 19.39% |
| 1990 | $1.97 | $0.40 | $0.16 | $0.24 | 20.43% |
| 1989 | $1.75 | $0.36 | $0.14 | $0.22 | 20.72% |
| 1988 | $1.56 | $0.31 | $0.12 | $0.19 | 20.04% |
| 1987 | $1.41 | $0.27 | $0.11 | $0.16 | 18.95% |
| 1986 | $1.28 | $0.23 | $0.10 | $0.13 | 17.70% |
We begin with book value (owners’ equity) from the balance sheet, which is the traditional accounting book value we are all familiar with. The academic research terms this “dirty” book value. Why do we begin with dirty balance sheet book value? It’s easier than going back to 1888 or so (yes, GE is a very old company) and trying to find beginning book value (owners’ equity). So we begin with dirty book value (owners’ equity) and clean it up.
Looking at the very bottom line, we begin by taking 1986 net income (not earnings) of $0.23 and then subtract $0.10 of dividends. This leaves us with $0.13 of retained earnings. We then add the retained earnings ending 1986 ($0.13) to the beginning 1986 book value ($1.28), which gives us beginning book value for 1987 of $1.41 (Table 11.3).
Table 11.3 General Electric (GE)
| Year | Owners’ Equity | Net Income | Dividends Paid | Retained Earnings | Return On Equity |
| 1987 | $1.41 | $0.27 | $0.11 | $0.16 | 18.95% |
| 1986 | $1.28 | $0.23 | $0.10 | $0.13 | 17.70% |
In order to calculate the ROE for 1986, we use the net income of $0.23 (return) and divide it by the book value (owners’ equity) of 1986 ($1.28) to obtain return on equity for 1986 of 17.70 percent.
And to find book value (owners’ equity) for the present year, we must add last period’s retained earnings (net income – dividends) to last period’s book value (owners’ equity). Just think of the bank account examples. It’s the exact same method. In this case, 1987 book value (BV) ($1.41) = 1986 BV ($1.28) + 1986 Retained Earnings (RE) ($0.13).
or
Now you understand why I had you look at the bank account examples so many times. You calculate the book value (owners’ equity) and ROE with stocks the exact same way you did with the bank accounts. Yes, it’s clean and simple.
Remember, we are going through these calculations so we can calculate the return on equity (ROE). A high and consistent ROE tells us most of what we need to know about a stock.
We are looking to see if the ROE developed from Clean Surplus Accounting lends itself to predictability. Rather than wait, I’ll tell you right now. The ROE certainly does indeed lend itself to predictability.
I Forget, What Are We Looking For? Let’s Review!
We are trying to find a comparable return on equity ROE ratio so that we may compare the operating efficiency of one company to the operating efficiency of any other company. In order to find a comparable ROE for all companies, we must configure both the return (net income) and the equity in the same manner for each and every company. Traditional accounting does not allow us to do this. Clean Surplus Accounting absolutely does allow us to do this.
The Clean Surplus asset base (owners’ equity or book value) is comprised of common stock sold to investors plus all Clean Surplus retained earnings (retained profits). Please remember that the Clean Surplus earnings number is actually net income: or, as they said in 1895, earnings before abnormal charges.
What have we accomplished here? Net income is configured before we adjust for individual, non-recurring company charges. Thus, net income is calculated the same among all companies up to the point of the non-recurring individual company charges.
Always remember that book value (owners’ equity) under Clean Surplus is comprised of the money the company raised through common stock sold to investors plus all Clean Surplus retained earnings. Clean Surplus retained earnings is net income minus dividends.
If owners’ equity is calculated in the same manner for all companies, then both the owners’ equity and net income (from which owners’ equity is derived) are common among all companies. If this is true, and it is, then the ROE ratio as configured by Clean Surplus Accounting is truly a comparable method of determining operating efficiency. And most importantly, this method is common to all companies.
I’m sorry if I sound like I’m repeating myself, but I’m trying to make sure you understand the basic premise of investing, which is evidently lost on most professional money managers. Ok, here we go.
Let’s now look at just the ROE of both General Electric and General Motors (GM), with the ROE configured using Clean Surplus Accounting shown in Table 11.4. We are looking only at the Clean Surplus ROEs for our comparison. Please note these ROEs stop at 2002 for this example.
Table 11.4 GE and GM ROE
| GM ROE | GE ROE | |
| Average | 7.4% | 20.6% |
| 2002 | 3.4% | 22.4% |
| 2001 | 4.7% | 22.1% |
| 2000 | 13.5% | 22.4% |
| 1999 | 15.2% | 21.0% |
| 1998 | 9.9% | 20.3% |
| 1997 | 16.8% | 20.2% |
| 1996 | 13.4% | 19.7% |
| 1995 | 19.9% | 19.5% |
| 1994 | 19.9% | 19.3% |
| 1993 | 7.1% | 18.8% |
| 1992 | −13.4% | 17.0% |
| 1991 | −19.0% | 19.4% |
| 1990 | −7.6% | 20.4% |
| 1989 | 12.6% | 20.7% |
| 1988 | 14.8% | 20.1% |
When using Clean Surplus Accounting, we see that GE has a high average ROE (20.6 percent) and a relatively consistent ROE, while GM has a low average ROE (7.4 percent) and a very inconsistent ROE. Again, please be aware that both ROEs were configured using Clean Surplus Accounting (bank account example), and not the traditional accounting ROE that we are so familiar with.
When you consider that the ROE is a measure of operating efficiency, we come to an age old question: If this were 2001 and you were looking at these numbers, would you rather invest in a very efficient company such as GE, or would you rather invest in a very inefficient company such as GM?
Remember that the market hates inconsistency. We see that General Motors has a negative ROE of 19 percent in 1991 and a positive 19.9 percent in 1994. In some years it is making a lot of money and in some years it is losing a lot of money.
Now look at General Electric. The ROE is high and very consistent, with a bias toward an increasing ROE. The market loves consistency, and the market rewards those companies that have a high and consistent ROE.
In the 10 years prior to 2002, GE stock increased from a split adjusted $6 per share to $24 per share for a 300 percent increase, not including dividends. During the same time period GM’s stock went from $35 to $33 for a loss except for dividends. Well, I guess what I said is true about the market rewarding a high and consistent ROE.
What you have discovered is a truly comparable method of determining operating efficiency. And this method is common to all companies.
The question we will answer a bit later in this book is whether the ROE is an indication of the future return of a portfolio. It certainly looks to be the case with GE and GM up to 2002.
Bottom line is if the ROE is an indication of the future returns, we can then fill our portfolios with stocks that have high and consistent ROEs and the rest will take care of itself. The answer to the question of ROE being an indicator of future returns will make you smile.
When we bring these two companies up to date in Chapter 14, you will see there was a time when GE just had to be sold.