This week, quite bored from hearing about the new CEO of Chipotle, I doodled a list of companies using their 2017 return on equity ratio as a ranking criteria. The return on equity of two companies stood out. First was Colgate-Palmolive, the company responsible for our teeth and body hygiene, had showed a net income of about $2 billion for 2017. More impressive though, Colgate generated its profit using a reported average book value of $130 million. This translates to a return on equity of 823%.
The second company was IBM, an American multinational technology company. As of December 2017, the company profited $5.75 billion on an average book value of $9.58 billion for that year. While not as conspicuous return on equity ratio as Colgate, IBM’s reported return on equity of 60% is remarkable. But is it real?
With the risk of oversimplification, I will remind the reader that the higher the return on equity ratio is, the more valuable the company. Here is why: say that earlier this year you bought a stock with a book value of $10 for $10 per share. In investing jargon, we would say that you had bought the stock of company ABC at par. Let us further assume that company ABC will earn a return on equity of 60% for the next five years. With the assumption that management will retain all earnings over the next five years, the book value per share will be $105 in 2023. And if the quoted market price remains at par the book value, your interest in the company will be worth $105.
Let us further assume that to you bought the stock of company XYZ at the same price. But company XYZ earned a 6% return on equity. In 2023, using all the same assumptions, the value of your stock in company XYZ will be only $13.38.
You can see how important the ratio is: a difference of 60% compared to a 6% return on equity, resulted in an eight times higher value.
Intrigued by Colgate’s outlandish return on equity ratio, I printed the 2017 Colgate-Palmolive annual report. Here is what I learned on page 68: The reported equity balance of $243 million consisted of a $20.18 billion deduction related to treasury stock (note: the deduction was in the billions, not millions).
Since management was purchasing the company's common stock in the market place over the past few years, the cost associated with the stock purchase was deducted from the equity balance. And the related line item was titled “Treasury Stock, At Cost.”
Let us delve further in the numbers. On page 87 of the annual report, management explained that it acquired 19,185,828 common stock in 2017. But certainly the average cost could not be $1,047 - which can be calculated as the cost of $20.1 billion divided by 19.18 million of common stock - since the stock traded as low as $69 and as high as $77 in 2017. So, to estimate the true average cost, I had to find how many shares the company had acquired to date, and for that, I turned to page 68, where management reported on the book value figures.
From here the math was simple: since management had issued 1,465,706,360 shares to date, and there are 874,701,118 shares outstanding, management had purchased 591,005,242 shares for a total cost of $20.1 billion or an average of $34 per share.
The reader will note that the basic rules of bookkeeping state that when a company purchases something - whether it is real estate, inventory, or in our case, common shares - that purchase is an asset by definition as it is expected to provide future income. And the economic truth behind the line item reported under the name "Treasury Stock, At Cost" is that it is a real asset, with not only a very real cost basis, but also with a very real market value.
I estimated the market value of the treasury stock to be at least $30 billion, after deducting future taxes on the capital gains. I then added that estimated market value of the treasury stock to the equity balance and calculated a paltry return on equity of about 6%.
(Note: throughout this article I calculated the return on equity using the year end profit in the nominator and the average equity balance in the denominator. Please write to me if you would like to understand better the logic behind the formula.)
“Manager and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation,” said the Oracle from Omaha. My goal in writing this article was not to offer the reader a better method or solution of how to account for treasury stock, nor to claim that management, through their accountants, is deliberately trying to fool us.
My intent was to illuminate how tricky accounting is. And to stress that it is the responsibility of the investor to understand the true economics of the business and not just to read what is being reported by the accountants.
Similar to most things in life, it is important to acquire knowledge. But it is more important what you do with that knowledge.