In part one, we provided a short background on ROE Disaggregration to determine “businesses earning good returns on equity while employing little or no debt”.
With that background, in this post, I calcuate the ratios and numbers for Oracle and SAP using the Balance Sheet and Income Statements from their latest 10-K filings. In order to do these calculations, we have to “recast” the income and balance sheet statement to segregrate the operational and non-operational components. I can provide the xls that contains these calculation to interested person, however, in this post, I am going to focus more on the analysis.
What do we observe from the numbers in the table above?
- SAP has almost 5 percentage points higher ROE compared to Oracle (27.32% vs 22.43%).
- However, as we discussed in part one, ROE could be misleading. We need to focus on the operational part – RNOA. Well, SAP has almost 6 percentage points advantage over Oracle ( 24.59 % vs 18.60%). In other words, operationally SAP is doing a good job of converting it’s operational assets into profit. Furthermore, for SAP, the non-operation return constitues only approx. 10% of the entire ROE versus 17% for oracle.
- What about the non-operatinal (financial) part? Oracle has 1.1% advantage over SAP ( 3.83% vs 2.73%). Oracle CFO is definitely doing a slightly better job in his investments.
- As we discussed, SPREAD is the difference between returns from borrowed funds and cost of borrowing. SAP has spread of 20.62% vs 13.00% for Oracle. Two reasons for SAP having higher spread: 1) SAP has higher RNOA as noted in #2 above and at the same time, effective rate of borrowing (net financial rate) for SAP is lower.
I think we get a good picture from the analysis above. Now, let us see how does the market view this two companies.
The market valuation ratios bear out the analysis above. On both counts, Price-to-earnings and Price-to-book value, SAP is rewarded by the market (slightly) . As we saw earlier, operationally, SAP is doing a better job on turning it’s operational assets to profit (higher RNOA).
In conclusion, in part one, we briefly described the methodology of disggregating ROE. In part two, we applied the methodology to Oracle and SAP. And further examining the market valuation ratios, we can, in this case, positively correlate the components of ROE to the market price. At the same time, as investors, we have to understand that ROE analysis is one of the tools in our pocket and not the only tool. And the market valuation takes into account several other factors that are not always captured quantitatively on the balance sheet (for e.g., management team, product pipeline, R&D talent, Brand, etc.).