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Calculation of Capital Employed from published balance sheets

Analysing companies' finances and value from their financial statements using ratios and formulae
Dod101
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Re: Calculation of Capital Employed from published balance sheets

#140935

Postby Dod101 » May 24th, 2018, 11:09 am

I agree with what you say. Actually what we are all illustrating now is that a little knowledge is a dangerous thing.

Dod

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Re: Calculation of Capital Employed from published balance sheets

#140948

Postby simoan » May 24th, 2018, 11:43 am

Dod101 wrote:I agree with what you say. Actually what we are all illustrating now is that a little knowledge is a dangerous thing.Dod

The main reason I'm responding on this thread is to try and help Matt & Mel out. I wish I'd had books like the one's I've linked to when I started out and fully grasped the importance of the psychological aspects of investing in the stock market. I'm not going to comment on the shares they've bought or how they might do in a bear market... that's for them to find out.

All the best, Si

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Re: Calculation of Capital Employed from published balance sheets

#140972

Postby Dod101 » May 24th, 2018, 1:17 pm

IMHO the psychological aspects of investing (as you phrase) are I think the most important parts added to what I term culture. If you can understand these items you do not need to worry about the mechanical bits like ROCE and the analysis of company accounts. You still need to use your judgement, art not science.

Dod

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Re: Calculation of Capital Employed from published balance sheets

#140993

Postby simoan » May 24th, 2018, 2:32 pm

Dod101 wrote:If you can understand these items you do not need to worry about the mechanical bits like ROCE and the analysis of company accounts. You still need to use your judgement, art not science.
Dod

Yes, there's still a lot of judgement involved but being able to read a results statement will keep you out of a lot of trouble and give you an edge, particularly if you invest mostly in small caps where the accounts are more compact and easier to understand. I can look at the balance sheet and income statement and quickly calculate ratios that are important to me e.g. ROCE, operating margin, current ratio. By comparing with previous results you can very quickly see if something has gone wrong and tell when the management guff at the top of the statement is papering over cracks - it often is! I would not try and dissuade Matt & Mel from doing this, it is a useful skill to have.

All the best, Si

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Re: Calculation of Capital Employed from published balance sheets

#141020

Postby Dod101 » May 24th, 2018, 4:36 pm

Neither would I simoan but I just think they and the rest of us ought also to note that balance sheet analysis is far from the be all and end all. I too can read company accounts and as you say or imply the trends are often more important than the actual figures for a given year. Of course analysis is a necessary skill to have but there is so much else to investing which is I think what makes it so fascinating.

Dod

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Re: Calculation of Capital Employed from published balance sheets

#141127

Postby TheMotorcycleBoy » May 25th, 2018, 6:07 am

simoan wrote:EDIT: Also, it's worth pointing out then when you say the ROCE is pathetic, you should not be using ROCE to compare with other companies in different industries. I can almost guarantee the ROCE of Aviva, Prudential, Old Mutual etc. are just as pathetic! If you're going to use ROCE use it to spot trends for the same company or for comparison to companies in the same industry only.

Sorry, I shouldn't have used the word pathetic, but rather "small in comparison to others". All of these values need to be taken in context before their numerical value can be judged as good or bad or irrelevant. I didn't think massively about it, and basically just sent my previous post as some point of debate, basically to discover when it's a useful number and when it's not. And of course, comparing like-for-like would be sensible thing to do too.

So fear not we won't be hunting through reams of L&G reports for ROCE data!

thanks again,
M&M

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Re: Calculation of Capital Employed from published balance sheets

#141204

Postby simoan » May 25th, 2018, 11:08 am

Melanie wrote:Sorry, I shouldn't have used the word pathetic, but rather "small in comparison to others". All of these values need to be taken in context before their numerical value can be judged as good or bad or irrelevant. I didn't think massively about it, and basically just sent my previous post as some point of debate, basically to discover when it's a useful number and when it's not. And of course, comparing like-for-like would be sensible thing to do too.

So fear not we won't be hunting through reams of L&G reports for ROCE data!

thanks again,
M&M

Nope. I think the correct word to use under normal circumstances for a ROCE of 0.5% is definitely pathetic!! That means for every £100 of capital the company employs it is generating only 50p of profit - that is truly pathetic! Even with record low interest rates you can earn more than that in a Cash ISA. Of course, this could happen when an otherwise good company goes through a rough patch, but if the long run average ROCE is 0.4% then they may as well pack up, return the capital to shareholders, and go home :-)

With regard to ROCE for financials... you will notice in the Appendix of the Phil Oakley book he provides some example numbers for all of the FTSE 100 constituents at the time of publication, however he only does this for 76 companies because he excludes all financial stocks. It would be nice if he explained more fully why he had done this to the casual reader but perhaps he does this in the main text of the book - I don't know because I have not read it recently.

All the best, Si

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Re: Calculation of Capital Employed from published balance sheets

#141242

Postby TheMotorcycleBoy » May 25th, 2018, 1:25 pm

simoan wrote:Nope. I think the correct word to use under normal circumstances for a ROCE of 0.5% is definitely pathetic!!

Actually I had a better think about this Simon.

So ROCE looks like this,

operating profit / capital employed


Right? And we can state that CE = total assets - current liabilities. Well an insurance / pension surely needs to have astronomically sized assets, and I speculate that those would be equity, gilts, cash, bonds, hedge funds etc. etc. and they will put all their customers premiums in those assets. Since those assets are investments, hopefully they'll yield a +ve return, but presumably that is used (in part) to fund the products (insurance payouts, and pension lump sums, etc. etc.) so those returns do not comprise the profit part of L&Gs Balance sheet....since they are handed back to the customers etc. etc.

Well at least that's what my mental model reveals to me. And given that pension firms these days boast very low charges, that means that only a small amount of the returns on the above assets get to be realised as the financial firms earnings, and hence returned to shareholders.

Or something like that....

Matt

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Re: Calculation of Capital Employed from published balance sheets

#141269

Postby simoan » May 25th, 2018, 2:49 pm

Melanie wrote:Right? And we can state that CE = total assets - current liabilities. Well an insurance / pension surely needs to have astronomically sized assets, and I speculate that those would be equity, gilts, cash, bonds, hedge funds etc. etc. and they will put all their customers premiums in those assets. Since those assets are investments, hopefully they'll yield a +ve return, but presumably that is used (in part) to fund the products (insurance payouts, and pension lump sums, etc. etc.) so those returns do not comprise the profit part of L&Gs Balance sheet....since they are handed back to the customers etc. etc.Matt

Matt,

Whilst I have no wish to look at L&G's balance sheet, I would doubt it contains anything classified as current assets or current liabilities, and as such no working capital in the traditional sense. So you are pretty much left with operating profit/long term assets which I believe would be termed "Return on Assets" (ROA) rather than ROCE. But you're right, an insurance company holds a humongous amount of assets and so the ROA would also be a very small number.

All the best, Si

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Re: Calculation of Capital Employed from published balance sheets

#141274

Postby TheMotorcycleBoy » May 25th, 2018, 3:00 pm

Melanie wrote:the profit part of L&Gs Balance sheet....since they are handed back to the customers etc. etc.

Sorry, just correcting myself, still learning accountancy jargon. Obviously the above should have read:

the profit part of L&Gs Income sheet.

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Re: Calculation of Capital Employed from published balance sheets

#141286

Postby Dod101 » May 25th, 2018, 3:48 pm

Actually the L & G Annual Report gives us a ROE (Return on Equity) which they tell us is 25.6%. That appears to be the measure that the financial companies use since HSBC quotes this figure as well, only in their case it is a very poor 5.9% which they acknowledge needs to be improved.

Dod

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Re: Calculation of Capital Employed from published balance sheets

#141457

Postby Dod101 » May 26th, 2018, 11:13 am

I might have added that L & G define ROE in their Glossary of terms used in their report as 'measuring the return earned by shareholder capital retained within the business. Calculated as profit after tax divided by average shareholders' funds (according to the IFRS definitions)

As long as all financial companies are using the same definition that seems to be to be a good comparator.

Incidentally although it is a somewhat dry read these glossaries are very useful for anyone trying to understand accounts.

Dod

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Re: Calculation of Capital Employed from published balance sheets

#141668

Postby simoan » May 27th, 2018, 12:43 pm

Dod,

Yes, ROE is the best measure of profitability for financials, but the same rules apply as before for ROCE:

1. Don't use the companies own measure! They can include and exclude what they like as ROE is not covered by any financial accounting standard, so they can buff it up to look as good as possible. This makes it useless for comparison with other companies. Use your own measure and stick to it, or use a reliable data source. My source tells me the L&G ROE was 21.2% for 2017.

2. Only use it to spot trends for the same company or comparison with very similar companies in the same industry.

The good things is the ROE includes debt leverage which is important for financials. The trouble is financial leverage can actually increase the ROE figure, so a high figure in itself is not always a good sign. I just checked the Phil Oakley book and he covers the topic of debt and the effect on financial ratios very well in Chapter 6. Having had a quick thumb through the book, I'd say that the chapter on debt, including the danger of pension deficits is probably the most important chapter of all, and so well worth reading.

All the best, Si

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Re: Calculation of Capital Employed from published balance sheets

#141670

Postby TheMotorcycleBoy » May 27th, 2018, 12:54 pm

simoan wrote: I just checked the Phil Oakley book and he covers the topic of debt and the effect on financial ratios very well in Chapter 6. Having had a quick thumb through the book, I'd say that the chapter on debt, including the danger of pension deficits is probably the most important chapter of all, and so well worth reading.

Yes, I've been looking at this book on and off in between reading "Planet Ponzi". The stuff about debt, esp. retailers hidden rent/lease liabilities is very revealing.

(Mel is currently reading "The Art of Execution" and finding that quite interesting).

I'm currently researching FCF and all it's uses and variations. Will probably post another topic soon - have found something else a little bit puzzling in Phil's book. :lol:

Matt

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Re: Calculation of Capital Employed from published balance sheets

#145025

Postby TheMotorcycleBoy » June 11th, 2018, 8:07 pm

I'm now calculating "Return on Equity" for a couple of firms using their reports. Phil Oakley in "How to pick quality shares" does not cover this at all, so after googling, I found a consensus of definitions, e.g.

http://www.investinganswers.com/financi ... ty-roe-916
https://corporatefinanceinstitute.com/r ... quity-roe/

as
ROE = Net Income / Shareholder’s Equity

(where "net income" == "net profit" == "profit after taxation")

And is "Shareholder's Equity", the same as the "Total Equity" (== "Net assets") figure which I'm seeing on a firm's balance sheet?

So taking Next from their 2014-15 balance sheet (page 82) as an example:
http://www.nextplc.co.uk/~/media/Files/ ... al-web.pdf

would that value be 321.9 ?

Assuming I'm right in all this, then for Next 2014-15:

ROE = (634.9 / 321.9) * 100  = 197%

Does that seem about right?

Other issues I'd like to clarify: I'm doing a kind of traffic light system for the parameters on our company valuation spreadsheet, so what kind of value for ROE would usually mean, "if less that x% stay away", and likewise what typically values between x% to y% would mean "possibly consider provided such-and-such criteria are met", and of course what value of z% implies "this firm is an absolute belter using this valuation parameter" etc.

Lastly, what kind of firms is ROE a good or bad parameter, and are they certain types of firm where ROCE is a better or worse measure and so on.

thanks
M&M

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Re: Calculation of Capital Employed from published balance sheets

#145242

Postby Gengulphus » June 12th, 2018, 4:45 pm

Melanie wrote:And is "Shareholder's Equity", the same as the "Total Equity" (== "Net assets") figure which I'm seeing on a firm's balance sheet?

Not quite. If you look at some companies' balance sheets, you'll find some sort of breakdown of the total equity / net assets figure into "Minority interests" (or similar wording) and "Shareholder equity" (again, or similar wording). If so, the latter is what you want. An example is Legal & General's 2017 annual report, where the following appears at the end of the equity section of the balance sheet:

Attributable to owners of the parent      7,843  6,945
Non-controlling interests 38 76 338
Total equity 7,919 7,283

The figure you want to use is the £7,843m figure for equity attributable to owners of the parent (i.e. Legal & General shareholders), not the total equity of £7,919m. It usually (as in this case) doesn't make much difference, though it could in theory make a difference of a factor of up to 2 (but less than 2 by at least a miniscule amount).

What is going on is that when company A owns more than half of the shares in company B, so that it controls company B no matter what the other shareholders of company B want, company B is counted as a 'subsidiary' of company A, and company A is the 'parent' of company B and indirectly of all its subsidiaries. It has got to be more than half - exactly half the shares isn't quite enough - but just half a share (if the number of shares in issue is odd) or one share (if it is even) more than half is enough. When a parent company's accounts are prepared, the full revenues, earnings, assets, liabilities, etc, of all of its subsidiaries are included (that's what the "Consolidated" in headings like "Consolidated Income Statement" and "Consolidated Balance Sheet" are referring to), but then at the end of those statements the amounts attributable to the other, minority shareholders of any subsidiaries the parent company doesn't own 100% are adjusted out. That's usually only a few subsidiaries, and the percentage of their shares not owned by the parent might be quite small as well, so usually it isn't a very big adjustment - but it could in theory be very nearly half of every subsidiary the parent owns that is adjusted out.

If you don't see such a breakdown in a company's accounts, by the way, don't worry: it almost certainly simply means that all the company's subsidiaries are 100% owned and so no adjustment is needed, and you can therefore use the total equity / net assets figure.

Sorry, I can't really say anything meaningful about your other questions.

Gengulphus

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Re: Calculation of Capital Employed from published balance sheets

#145291

Postby TheMotorcycleBoy » June 12th, 2018, 7:09 pm

Gengulphus wrote:The figure you want to use is the £7,843m figure for equity attributable to owners of the parent (i.e. Legal & General shareholders), not the total equity of £7,919m. It usually (as in this case) doesn't make much difference, though it could in theory make a difference of a factor of up to 2 (but less than 2 by at least a miniscule amount).

What is going on is that when company A owns more than half of the shares in company B, so that it controls company B no matter what the other shareholders of company B want, company B is counted as a 'subsidiary' of company A, and company A is the 'parent' of company B and indirectly of all its subsidiaries. It has got to be more than half - exactly half the shares isn't quite enough - but just half a share (if the number of shares in issue is odd) or one share (if it is even) more than half is enough. When a parent company's accounts are prepared, the full revenues, earnings, assets, liabilities, etc, of all of its subsidiaries are included (that's what the "Consolidated" in headings like "Consolidated Income Statement" and "Consolidated Balance Sheet" are referring to), but then at the end of those statements the amounts attributable to the other, minority shareholders of any subsidiaries the parent company doesn't own 100% are adjusted out. That's usually only a few subsidiaries, and the percentage of their shares not owned by the parent might be quite small as well, so usually it isn't a very big adjustment - but it could in theory be very nearly half of every subsidiary the parent owns that is adjusted out.

If you don't see such a breakdown in a company's accounts, by the way, don't worry: it almost certainly simply means that all the company's subsidiaries are 100% owned and so no adjustment is needed, and you can therefore use the total equity / net assets figure.

Thanks, Geng,

Ok, I'm clear (I think) about the notion of the parent company and it's subsidiaries of which the parent owns a majority (>50%) holding.

So it looks as if we should include a cell to enter Non-controlling interests in our spreadsheet, or otherwise and thus.....hmm....just taking a quick look at the NXT AR, that I'm using as a reference:

http://www.nextplc.co.uk/~/media/Files/ ... al-web.pdf

Oh my..this analysis has now become very confusing. I now see that in this report whilst there is a consolidated balance sheet (pg 82) (along with corresponding income, and cash flow statements), there is also a parent company balance sheet (pg 119). And I note that the consolidated sheet states only 321.9M of Total Equity, whereas the parent company sheet states 1,445.6M of Total Equity.

So I'm now curious as to where these two different balance sheets stand in the order of things....and secondly which of these two should I (who does not want to delve any deeper than necessary) refer to when compiling a company valuation spreadsheet?

thanks Matt

PS. Looks like my only blessing is that I could don't (immediately) see comparable Income and Cash Flow sheets for the "Parent Company" :lol:

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Re: Calculation of Capital Employed from published balance sheets

#145296

Postby Gengulphus » June 12th, 2018, 7:25 pm

Melanie wrote:Oh my..this analysis has now become very confusing. I now see that in this report whilst there is a consolidated balance sheet (pg 82) (along with corresponding income, and cash flow statements), there is also a parent company balance sheet (pg 119). And I note that the consolidated sheet states only 321.9M of Total Equity, whereas the parent company sheet states 1,445.6M of Total Equity.

The parent company balance sheet is for the parent company's assets and liabilities only, without the subsidiaries, and (without looking - I'm short of time) that presumably means that the subsidiaries have negative net assets / equity, i.e. more liabilities than assets.

Gengulphus

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Re: Calculation of Capital Employed from published balance sheets

#145297

Postby TheMotorcycleBoy » June 12th, 2018, 7:34 pm

Gengulphus wrote:
Melanie wrote:Oh my..this analysis has now become very confusing. I now see that in this report whilst there is a consolidated balance sheet (pg 82) (along with corresponding income, and cash flow statements), there is also a parent company balance sheet (pg 119). And I note that the consolidated sheet states only 321.9M of Total Equity, whereas the parent company sheet states 1,445.6M of Total Equity.

The parent company balance sheet is for the parent company's assets and liabilities only, without the subsidiaries, and (without looking - I'm short of time) that presumably means that the subsidiaries have negative net assets / equity, i.e. more liabilities than assets.

Gengulphus


Thanks again, so presumably we should stick to the "Consolidated" sheets on an AR like this, for a more accurate representation of the firm overall?

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Re: Calculation of Capital Employed from published balance sheets

#145310

Postby Bouleversee » June 12th, 2018, 8:33 pm

After reading through all this, I think I may be losing the will to live. However, I think I now understand why on one of my platforms I was perplexed to read that either Scottish Mortgage IT or Monks IT had an ROCE of zero. OTOH since both websites were recently changed, many of the figures are rubbish. What a pity I didn't read any of these books and comments 50 years ago but then at that time I was busy enjoying life and had a good stockbroker.


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