The 3 R’s of Finance

The term “return” is often used in finance. While technical jargon has a tendency to make “returns” sound complicated, the word simply means a change in value.

The formula of a return

Companies are often complex and investors use “return ratios” to gauge the past profitability of a specific part of the company, or the company as a whole. This information can then be used to compare different investment opportunities.

The three ratios below are some of the most popular “return ratios” investors look at. While each one is valuable, no single ratio should be used as an gauge of the overall prospect of a firm.

 

Formula Return on Assets ROA

Return on Assets (ROA) is net income divided by total assets. ROA illustrates how efficiently a firm is using its assets to generate earnings. This ratio is often used for comparing firms within the same industry and with a similar capital structure. A higher number is indicative of a company that is producing larger profits from fewer assets. Investors should be weary that a company holding excess cash or assets can have a lower ROA. Check a firm’s balance sheet for clarity.

 

Formula Return on Equity ROE

Return on Equity (ROE) is net income divided by shareholder’s equity. ROE is expressed as a percentage and shows how profitable a firm is with the money given to it by equity investors (aka shareholders). Again, this ratio is useful for comparing the profitability of a company to that of other firms in the same industry. Averaging past ROE’s can give an investor a better idea of historical growth.

 

Formula Return on Invested Capital ROIC

Return on Invested Capital (ROIC) is net operating profits after taxes (NOPAT) divided by invested capital. ROIC demonstrates how efficient a firm was in investing its capital in different projects. Unfortunately, this metric doesn’t specify if the return is from a onetime event or a recurring event, but to find out, simply read a company’s recent annual and quarterly reports. Unlike ROA and ROE, this ratio can be used to compare firms with different capital structures across industries.

While ROIC on its own can be useful to investors, comparing it against the weighted average cost of capital (WACC) can reveal if a firm is creating or destroying value for shareholders. While WACC is fairly complicated and very well could be the subject of its own post, it is simply the minimum rate of return that a firm needs to return to the shareholders. When ROIC is greater than WACC, shareholder value is being created, and when the inverse occurs, value is being destroyed. A firm with a higher spread between ROIC and WACC tends to create more value than its competitors.

Want to learn more about value investing? Check out The Intelligent Investor by Benjamin Graham.

I put off writing this…

“By the streets of by and by, one arrives at the house of never.”

Procrastination.

Our tendency to do it can waste away hours. In fact, there’s a good chance that you’re doing it right now.

Facebook, Twitter, Reddit… even Joshsauer.com. The list of websites we can spend our time on is endless, and despite the seemingly trivial nature of these sites, we often find ourselves spending hours on end browsing through them the night before a big test or essay is due.

We’ve all been there before, but why?

As it turns out, human motivation is highly influenced by how imminent a reward is perceived to be. The further away a reward is, the more we discount its value. (Similarly, when dealing with the time value of money, a dollar today is worth more than a dollar in the future.) This process is known as Hyperbolic Discounting, or more commonly as Present Bias.

Hyperbolic Discounting

 

Our tendency to place a higher value on short-term events makes surfing the web, talking with friends, or just about any mindless activity more important than studying for that big exam.

As your 8 a.m. test approaches, you begin to place a higher value on getting a good grade (studying). When this reward is greater than the one presented by checking Facebook, you have defeated procrastination. This phenomenon is known as Temporal Proximity.  Unfortunately, for most of us this process takes place around three in the morning, which leaves us little time to adequately prepare ourselves.

Temporal Proximity Procrastination

So, now that you know why procrastination happens, you probably want to know how you can beat it. Ultimately, it comes down to willpower. Nevertheless, here are 4 strategies that can help you defeat procrastination:

  1. Unplug
  2. Ditch the distractions. Turn off the music, close your browser and get focused.

  3. The Pomodoro Technique
  4. I know this sounds like it was invented by a famous bull fighter, but it’s just a fancy way of saying work in intervals.

    Set a timer for a set period of time and stay concentrated on your work until the timer goes off. When it does, reward yourself. A food break, 5 minutes of internet- something that is short, yet rewarding. Gradually increase the time in-between breaks and you’ll become disciplined in no time.

  5. Get Started
  6. Studies show that the greatest barrier to productivity is actually starting a task. A phenomenon known as the Zeigarnik Effect suggests that humans are compelled to finish a task once they’ve started it.

  7. Metacognition
  8. These techniques will work for some, but everyone functions differently. Now that you understand how procrastination works and acknowledge that you do it, you can develop your own personal techniques to overcome it.

The Fallacy of The Minimum Wage

The minimum wage is currently $7.25.

The unemployment rate is currently 7.4%.

These figures have more than the number seven in common.

 

The idea behind FDR’s 1938 establishment of the minimum wage was simple: increase the earning power of workers. In theory that sounds great; I mean, who wouldn’t want more money? But why don’t we raise the minimum wage to $20? Heck, why stop there? Why not raise it to $100?

Numbers like these help to more clearly illustrate the red headed step brother of minimum wage: Unemployment.

Behind every worker is an employer. Businesses will only operate when revenues are greater than expenses. In other words, they need to make a profit:

Revenues- Expenses = Profit

When hourly pay is increased, expenses rise accordingly. For some businesses, expenses become greater than revenues.  If that trend continues for a prolonged period of time, the businesses will eventually close their doors and layoff their workers. As fewer businesses operate, fewer workers are needed.

Minimum wage with government Josh Sauer

 Note: The difference between Supply for workers and the Demand is Unemployment.

If the minimum wage was lower- or better yet, did not exist- more businesses would be able to afford workers. Cheaper businesses would operate, and the forces of supply and demand would determine the “minimum wage.” Given the choice between unemployment and a lower wage, I venture to say workers would select the latter.

 

Minimum wage no government Josh Sauer

 

Legislation like the Fair Labor Standards Act of 1938 is often enacted with good intentions. Unfortunately, good intentions are not synonymous with good ideas; the fallacy of the minimum wage is an unfortunate example of this fact.

 

Like this post? Then you’ll love A Common Sense Guide to the Economy by Thomas Sowell.