Owners and Management

Owners evaluate the profits (not the wealth) with two statistics:

• ROE (Return On Equity)
• EPS (Earnings Per Share)

The dollar amount of the profits is actually secondary to Owners, although primary to Management. It is one thing to say, "Our profits were $10 million", and another to say, "Our profits per share were one dollar."

ROE = Profits/Equity = Profits/Assets * Assets/Equity = ROA * Leverage

EPS = Profits/Shares Outstanding

From Management's standpoint, ROA is more useful than ROE, because it indicates how good they are at producing wealth from the Assets. For example, a 10% ROA would delight Management because, if they can retain the earnings, they grew the asset base by 10% in a single year. However, Owner's want a return on the money they invested, their Equity. If Leverage is 1.0 (no debt) their ROE becomes 10% * 1.0 = 10%. If Leverage is 2.0, their ROE becomes 10% * 2.0 = 20%.

From an Owner's viewpoint, Management should use Leverage to produce higher ROE. The higher returns become EPS. The EPS can now be given to the stockholder as a dividend. This puts cash into the Owner's pocket while increasing the value of the stock. Stock price goes up. Market Capitalization goes up. This is yet another reason why a stockholder would prefer that Management maintain the Leverage and pay out dividends.

If your performance measures favor stockholders, they include ROE, Stock Price, and Market Capitalization. You should maintain Leverage.

However, if your performance measures favor Management, they include ROA (Profit/Assets), ROS (Profit/Sales), and Cumulative Profit. You should reduce Leverage.

The remaining two measures, Asset Turnover and Market Share, are somewhat neutral to Leverage, particularly in the latter years.

For the purposes of the Financial Structure category, stockholder's interests reign supreme. Your Leverage should fall between 1.81 and 2.8. But depending upon the measures you selected, you could find yourself conflicted.

Finally, let's step outside the simulation and take a look at a pragmatic reason why Management in publicly held companies tends to maintain high Leverage.

Managers wish to keep their jobs. They can lose their jobs two ways. Stockholder's have the power to remove managers for dismal returns. Other managers, corporate raiders, could take over their company and fire them.

Suppose that your company has a Leverage of 1.0 (no debt) and Total Assets of $150 million. Stock price and market capitalization are below what they would be at a higher Leverage, making the company a bargain. Although this is not possible in the simulation, a real-world raider would recognize that at a Leverage of 2.0, your assets could raise $150 million, and at a Leverage of 3.0, $300 million. The details of hostile takeovers vary enormously, but the essential characteristic of this particular deal is that your own debt capacity would be used against you.