Economic performance
Management flattering themselves
On January 13, 2023 JPMorgan announced its then latest financial results in a press release. The press release began with these words: “Jamie Dimon, Chairman and CEO, commented on the financial results: ‘JPMorgan Chase reported strong results in the fourth quarter as we earned $11.0 billion in net income, $34.5 billion in revenue and an ROTCE of 20%, while maintaining a fortress balance sheet and making all necessary investments.’”
In my view, the use and reporting of ROTCE is part of a con game practiced by the banking industry. ROTCE gives a false impression of the economic performance of banks and is misleading. It unduly flatters management. I suspect Jamie Dimon lends his name to this because his bank and almost all others in the banking industry have been using ROTCE for decades and have gotten away with it. I suppose they figure that if everyone else is doing it, they should too.
What is ROTCE?
Return on tangible common equity (ROTCE) is claimed to be a preferred measure of the economic performance of banks. It requires two inputs; the bank’s net income and the book value of the bank’s tangible assets.
Years ago, I was taken in by the con. I thought that using tangible assets in the calculation was somehow conservative and, well, tangible.
JPMorgan explains in the press release how it gets to the book value of tangible assets. “TCE represents the Firm’s common stockholders’ equity (i.e., total stockholders’ equity less preferred stock) less goodwill and identifiable intangible assets (other than mortgage servicing rights), net of related deferred tax liabilities.” (Emphasis added)
To exclude goodwill and intangible assets from a measure of economic performance is a sin.
Over 80% of the market capitalization of S&P 500 companies consists of intangible assets. Any investor who is not completely familiar with the rise over the last fifty years of company investment in intangibles of lasting value needs to read up on the subject. At the end of this post, I give links to posts on the subject and the discussion in the Motherlode.
Two points
The main point of this post is that the use of ROTCE by banks and some other financial institutions is misleading. Another point I have made in other posts is that with the rise over many decades of company investment in intangible assets of lasting value that do not appear on balance sheets, the popular metric of ROE is becoming obsolete. This is because the ‘equity’ part of the formula misses massive intangible assets that the company and its management have at their disposal.
A tangible example
To illustrate my first point, take a look at the following chart that comes from the 2020 annual report of The Charles Schwab Corporation. The company is a discount broker that is also a bank. In 2020 Schwab acquired TD Ameritrade. This was a massive acquisition. It was made at a price higher than TD Ameritrade’s book value. This meant that the difference between the price and TD Ameritrade’s book value was put on Schwab’s balance sheet as goodwill, i.e., an intangible asset.
Schwab explains in that report: “Return on equity contracted approximately 10 percentage points to 9% as reduced earnings power from ultra-low interest rates and the creation of sizeable intangible assets related to our acquisition weighed on the calculation.” It is not explained what impact each factor had. It is obvious that the booking of accounting goodwill was very significant.
Helpfully, Schwab calculates ROE for 2016 through 2020 and also ROTCE just for 2020 so we can see the impact.
How did we get in this pickle?
Bank capital is regulated. The focus of this regulation is tangible assets. That’s because banks’ business model is highly levered and it is essentially the tangible assets that indicate financial strength and stability. From this, banks took to touting their ROTCE rather than ROE.
World is changing
Some bankers realize ROTCE is not a fair measure of performance. For example, on March 1, 2023, on the first quarter conference call, Dave McKay, the president and CEO of the Royal Bank of Canada (Canada’s largest bank) said: “We continue to be well-positioned to deliver a premium return on equity (ROE) and compounding strong book value growth. This is underpinned by prudent growth in our many high-ROE businesses, including Canadian Personal Banking, global Wealth & Asset Management, and Investment Banking.”
By putting ROE up front and not touting ROTCE, the Royal Bank is making a more forthright presentation.
I should add that the Royal Bank of Canada and almost all other banks still offer ROTCE calculations in their reports. At least Dave McKay used ROE up front, unlike Jamie Dimon.
We are easily confused. The Economist Magazine recently had an article discussing bank returns on equity and comparing the U.S. and Europe. It was not clear whether the measure being discussed was ROE or ROTCE. For example, the article says: “J P Morgan Chase, a bank, predicts such costs alone could trim returns on tangible equity by one percentage point.”
Conclusion
CEOs, whether of banks or other public companies, like to show themselves in their best light. Most investors with any experience are alert to that. But, sometimes ‘best light’ is misleading. I prefer to invest in companies whose CEOs are completely forthright and not feeding me a line.
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To read further on this topic take a look at the Motherlode Section 35.04 Accounting treatment of intangibles.
You might also check out these posts:
Stock valuation in an age of intangible assets
Be wary of using Return on Capital (ROC)
The fading usefulness of book value
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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You can also use the word search feature on the right-hand side of this page to find references in both blog posts and also in the Motherlode.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
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