Gloria,
These are good, intelligent points you raise. Let me respond to the second one first.
You are wondering what is the best measure of Starbuck's actual intrinsic profitability, ROE or ROA. Both of these measures are approximations so we have to look behind the numbers. ROA tends to underestimate profitability because it doesn't account for legitimate liabilities such as accounts payable and most of the current liabilities. ROE, on the other hand, will usually overestimate true profitability if the company is using leverage, that is, long term debt. BOTH ROA and ROE will underestimate profitability if there are "dead" assets on the balance sheet, such as idle cash or too high inventories.
To find true profitability we have to make some adjustments to the balance sheet and the income statement. Look on the balance sheet and start with Shareholders' Equity. The idea is to remove anything that isn't needed to run the business. Starting with the asset side, subtract any excess cash that might be sitting there unused. Also estimate a reasonable inventory level (using past history) and remove any excess. Anything you remove from the asset side should be subtracted from Shareholders' Equity. Next look at the Liabilities. On this side it's mostly debt you are interested in. Take off any long term debt because debt isn't necessary to run the business. Add that number back to Shareholders' Equity. Once you've done all this you have a properly adjusted value of Shareholders' Equity for calculating true profitability.
Next go to the Income statement. Make any necessary changes here to account for the adjustments you made on the balance sheet. For example, if you took out excess cash make sure you also take out interest earned on that cash. If you took out long term debt, take out interest paid on that debt. These adjustments will affect pretax earnings so you have to adjust the amount of tax also.
Now you have 2 realistic numbers, but your not done yet! Because the balance sheet is in constant flux you have to go back 4 quarters and do the same calculation for each. In the end you will have 5 numbers. You then average these. Then you do the same with the earnings for the last 4 quarters. You adjust them as above then take an average. In the case of earnings there will be 4 numbers. Finally, you divide your adjusted earnings number into your adjusted equity number and you arive at a very accurate portrayal of true profitability.
The final number will fall somewhere in between ROE and ROA. In the case of Starbucks it will be between 6 and 10. My guess is about 8. But you can do the numbers (or I will) and we will know for sure.
Let me respond to your point about franchising another time.
Thanks for your thoughtful analysis. Keep it coming.
Rod |
