Return on Equity in Presence of Large Treasury Stock Balance
NJ Simpson Inc. reported the following equity accounts in its 2017 balance sheet. Stock prices for the past three year-ends of 2017, 2016, and 2015 are: $244.80, $196.96, and $136.34, respectively.
Shareholders’ Equity ($ millions, expect par and shares) 2017 2016 2015
Common stock — par value $1 per share (authorized 70,000,000 shares; issued 40,000,000 shares) $40 $40 $40 Additional paid-in capital 1,240 1,240 1,240
Accumulated other comprehensive income 108 (96) (220)
Retained earnings 1,419 1,340 1,209
Stockholders’ equity before treasury stock 2,807 2,524 2,269
Less: common stock held in treasury, at cost (15,360,000, 10,336,000, and 980,000 shares, respectively)
(2,776) (1,844) (114)
Total shareholders’ equity 31 680 2,155
Equity attributable to noncontrolling interest (6) (6) (6)
Equity attributable to company shareholders $25 $674 $2,149
The income statement for NJ Simpson Inc. reports the following.
$ millions 2017 2016 2015
Earnings attributable to company shareholders $403 $301 $217
Consolidated net income 409 303 218
a. Compute return on equity for 2017 and 2016, under the following assumptions.
Traditional definition of equity.
With adding back treasury stock to equity.
Using market value of equity instead of book value.
Round answers to one decimal place (ex: 0.2345 = 23.5%)
ROE computation 2017 2016
Traditional Answer % Answer %
No treasury stock Answer % Answer %
Market value of equity Answer % Answer %
b. Which of these metrics do we believe best measures the company’s return for the past two years?
Traditional ROE is inflated by the small equity balance in the denominator. This version does not truly measure the company’s performance.
ROE with no treasury stock is inflated by the small equity balance in the demoniator as it assumes the company could sell the treasury stock and add the cash to assets.
ROE using market value potentially overstates current period performance because the ratio includes the company’s high stock price, which by definition impounds future earnings.
All of these statements are correct.