- The element of the DuPont Analysis that one company has consistently outperformed the other by the largest percentage would be financial leverage.
ROE Analysis
- Home Depot’s ROCE decreased dramatically in 2018 and 2019 due to a negative total
shareholder’s equity balance.
- What is the cause of the negative equity balance for Home Depot?
The cause of Home Depot’s negative equity balance is due to an increase in the Treasury Stock account, which is common stock repurchased by the issuing corporation (in this case, Home Depot). Treasury stock is a negative amount in the calculation of equity, because it represents the difference between the value of total stock issued and the value of total stock outstanding.
- Is this an accounting issue or a risky move by management?
The primary reason for Home Depot’s negative equity balance, stock repurchasing, is a risky move by management. While there are several benefits to stock buybacks, there are several significant risks as well. There is no guarantee that the price of the stock will rise after the repurchase. If the stock price falls, then the existing shareholders will suffer severe consequences. Stock buybacks are often easy ways for a company to “artificially” increase its EPS without actually engaging in an activity to increase its financial position. Home Depot’s management should consider using adjusted EPS targets that account for stock repurchases.
While stock repurchases may be a sign that the firm believes its stock is undervalued, there is no guarantee the stock will rise as the repurchase plan is executed, and if the firm’s stock falls then the buyback can be particularly detrimental to continuing shareholders. In addition, repurchases will result in higher EPS so caution should be exercised if management bonus plans are based upon EPS targets that have not been or will not be adjusted for buybacks.
- Do you think that the negative ROE should be a concern for Home Depot investors? Explain your answer.
A large amount of treasury stock contributes to Home Depot’s negative ROE, but is not the only factor. Home Depot’s retained earnings has also decreased, as well as the company’s carrying of an “accumulated other comprehensive loss”, due to negative OCI (other comprehensive income). While decreases in retained earnings can often be attributed to a company’s dividends that are paid out to investors, an “accumulated other comprehensive loss” is discouraging to investors because it often represents unrealized losses that will be recognized in the future. Also, investors should be wary of the fact that their EPS in Home Depot’s stock will increase “artificially”, not because of the company’s positive performance. Also, the increase in stock price usually is only short-term, as eventually the market will react to the fact that the corporation’s financial outlook did not actually change. Investors who buy stock right after a stock may actually lose money on their investment.
- Why would management take these actions that cause a negative equity balance?
When a corporation repurchases stock, it is often set aside to either raise funds or pay for future investments. An impact of repurchased stock is that the number of shares outstanding in the market decreases, which causes an increase in EPS for the remaining shares which are owned by stockholders. Management often buys back stock when they believe it is undervalued, which is a solid investment for the company and often raises share prices. Share prices often increase because a reduction in the number of outstanding shares creates a shock to the “supply and demand” of the company’s stock. Therefore, there are a variety of reasons why management would want to buy back some of its outstanding stock.
- Given Home Depot’s negative ROE, what other metrics might you use to compare Home Depot to competitors when assessing overall profitability for owners? Explain why these measures would be useful.
In addition to ROE, other metrics that can be utilized to measure Home Depot’s overall profitability for its owners include:
- Earnings per Share (EPS)
- EPS measures the amount of net income earned by each common share. It is used as the traditional measure to value income for stockholders.
- Price to Earnings
- This measure serves a dual purpose. It can be used to compare company valuations to one another, as well as the value that investors place per dollar of earnings.
- Market (or Price) to Book
- This is the ratio of the market’s value of equity to the corporation’s book value of equity. It is useful to determine if the accounting records might overstate or understate the value of the company’s equity.
- Dividend Yield
- The dividend yield represents the percentage of share price distributed in dividends. Stockholders are interested to learn if they are actually generating timely returns on the value of shares.
- Total Shareholder Return
- Total Shareholder Return is an excellent measure that takes into account the value of an owner’s investment at the beginning to the end of the year, as well as dividends. It measures the total amount of return that an investor earned in a specific year.
- Dividend Payout
- This measure is similar to the dividend yield, but considers overall company profits. It is the percentage of earnings that are distributed as cash dividends to stockholders.
