Tag Archives: Gaenor Lipson

What moved your favourite share’s price?

Learn about “Roam” – return on assets managed – and you’ll be all the wiser, writes Gaenor Lipson.

Ted Black

SABMILLER SHOCK: Ted Black says the brewer’s asset turnover no longer looks very healthy.

HOW do you measure what a company is worth at present, and therefore how much a share in it should cost? In other words, how do you rate a firm’s financial health in order to get a feeling for its prospects in the future?

The authors of Who Moved My Share Price? made a name for themselves by picking holes in Dimension Data’s operating principles, and — in the minds of many people — predicting the former JSE highflier’s demise.

The book is about the importance of “Roam” — return on assets managed — in determining the value of a company.

The ratio is calculated by comparing two figures. The first is asset turnover, derived by dividing sales by assets. The second is return on sales. To get this figure, divide profit (or earnings before interest and tax) by sales, and convert it into a percentage.

More recently, Ted Black and Andy Andrews have turned their guns on SABMiller. Based on their formula, the brewer fails the test of strength.

What makes Black so sure that it is worth investors taking a long, hard look at their favourite company’s operational history?

Asset turnover is the most important measure in the equation, he says. In the case of SABMiller, “I am not saying they are going under. I am simply pointing out that their asset turnover halved from 1.6 to 0.8 before the Miller acquisition, and Roam plunged,” he says.

“This is despite a very healthy return on sales of 16%. A sharply declining asset turnover is a warning bell and SABMiller’s management had better pay attention to it — as should their shareholders.” Black is critical of SA’s top management, which he says rarely uses the Roam formula.

“Some look at assets versus earnings and others ignore the assets altogether and focus purely on earnings in isolation. This can and has led to ill-advised acquisition strategies. Meanwhile, people lower down in the organisation do the asset managing, but don’t know about Roam.”

Many managers look only at the immediate business information, such as comparisons on a quarterly basis, says Black.

“They do not look at the data trends or the history of the company, the so-called big picture. Therefore, when the company runs into problems, such as poorly thought-out strategies that lead to a decrease in the productivity of assets, management’s response is to lay off workers.”

Black says a key question to ask managers is: “What is the smallest, easiest, least expensive change we can make that gives the largest measure of sustainable improvement?” Roam, he says, allows managers to design projects that can leverage both productivity and their own personal growth.

He and a colleague, Gerard van Hoek, are teaching Roam at Sasol to everyone from senior managers to mechanics, with a focus on projects that make assets more productive. Black regards US personal computer manufacturer Dell as “getting asset management right”. He says: “It has negative working capital ... a stock turnover of 90 per year and they get paid before they pay their suppliers — just like Pick ’n Pay, another company that knows about asset turnover.”

Keep an eye on how assets perform

RETURN on assets managed is a vital measure of a company’s value, say Arjen Lugtenburg, a portfolio manager at Allan Gray, and Rodger Walters of Abvest Associates.

Walters says: “It is one of the ratios I look at in understanding what a company does and how profits are generated.”

He says companies can have a declining Roam for valid reasons, such as the start-up of a new business or division. In this situation, there could be a large outlay of capital before a profit is made.

Another good reason could be a large capital outlay for assets that will last for years, even decades — for example, the stainless steel vats that brewers use, or printing presses that can last up to 20 years if they receive proper care.

However the purchase of an existing business is not a valid reason for a decline in Roam, says Walters: “If Roam declines, it means that the new business does not have sufficient earnings, but has increased the size of the company’s assets.”

He says it is important to know what was paid for the new business and what the competition would have paid.

Lugtenburg says assets that generate relatively high returns come with a relatively higher price tag. This is because the company can grow faster with less new capital. But companies must ensure that they do not overpay, which is what happened with Dimension Data. He says the IT company did not account for its equity properly.

If it had, it would have been apparent that the asset base had enlarged without earnings increasing to the same extent.

“This fact was hidden by the issuing of new shares at a very high multiple.

“This enabled them to access capital at a very low cost.”

Roaming for the right measure

CHARTERED financial analyst Charles Hattingh is a great fan of the “return on assets managed” ratio.

Roam, he says, gives a clearer picture of a company’s health than a commonly used measure, Ebitda — earnings before interest, tax, depreciation and amortisation.

He says Ebitda is “a fad” and adds: “It is a pathetic attempt to arrive at a surrogate for cash flows attributable to the operations of the company.” Here is why:

  • “Earnings can and have been manipulated by management to make headline earnings a share look good.
  • Interest is excluded from this measure, which encourages a company to gear its operations at the expense of increasing financial risk,” says Hattingh. “It also encourages the company to capitalise operating leases, which transfers rental expenses out of operating expenses and into interest and depreciation.
  • Tax is — but should not be — ignored as it is part of cash flow. Accelerated tax allowances can lead to tax being expensed totally out of line with the tax paid. The end result of discounting pre-tax cash flow at a pre-tax rate can be very different to discounting posttax cash flow at a post-tax rate.
  • Depreciation, like tax, is a cash flow, as it includes items such as rental. Capitalise leases and suddenly cash flows increase.
  • “Amortisation would not be a cash flow item if a company never had to replace the asset being amortised.” Against this, Hattingh prefers Roam, which recognises tangible measures such as:
  • Margin (operating profit after tax but before taxed interest, divided by sales); and
  • Operating gearing (sales divided by operating assets).

Written by Gaenor Lipson.