Return on equity is an oft-touted factor in making investment decisions. While it shows shareholders' total returns, it fails to consider investors' required return. A measure known as residual income adjusts for the required return. That can help investors determine which investments offer the best returns over the minimum required.
In industries with several strong players, returns on equity may not provide accurate differences among the companies. Stores such as
look solid, but determining which will compensate its shareholders the most can be learned by using residual income.
The theory behind residual income is that a firm's net income doesn't account for the cost of equity funding the company's operations. As a result, return on equity actually could be below the return required by investors given the level of risk. In that case, the company is failing to generate sufficient profits to compensate equity holders.
Adjusting for this fault is simple. Since earnings per share can be backed into by multiplying the return on equity by the book value per share, and the cost of equity per share can be understood by multiplying the required return by the book value per share, the difference between earnings per share and the cost of equity per share results in residual income.
More simply, the equation can be written the following way:
Residual income = (return on equity - required return) x book value per share.
Applying this formula to retail stocks results in the following:
Wal-Mart's residual income is far above that of Target and Costco. When comparing the figures on the basis of price per share, Wal-Mart is trading at a multiple of residual income of about 18.5 times, while Target and Costco are trading at multiples of 51.5 and 61 times, respectively.
While that result is far from earth-shaking, what's more intriguing is the comparison of Wal-Mart to a discount retailer like
Family Dollar Stores
. Family Dollar posts a residual income of $1.43. However, its residual income multiple is only 19.5. This places it just below Wal-Mart in terms of price to residual income valuation, suggesting a comparable value even though they are miles apart in terms of size and notoriety.
Other retailers, such as
, prove to be wildly overpriced based on residual income. The return on equity for Amazon looks impressive at 30.95%. But after adjusting for the required return, Amazon posts a residual income multiple of more than 62.
As a result of Wal-Mart's superior residual income, the company has been less affected by the economic downturn than Target or Costco have. In the past year, Wal-Mart's stock has fallen 14.2% vs. 21% for Target and 38% for Costco. The order of those declines is the same as the results of the residual income analysis.
Clearly, firms with stronger residual income are better suited to survive during economic routs.
TSC Ratings provides exclusive stock, ETF and mutual fund ratings and commentary based on award-winning, proprietary tools. Its "safety first" approach to investing aims to reduce risk while seeking solid outperformance on a total return basis.
Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level II CFA candidate.