Each link in the ROE chain has its own component drivers. For instance, strategic financials such as gross margins and expenses drive profitability. Asset levels, quality, and turnover drive productivity, while debt and new capital requirements drive capital structure. In turn, strategic intangibles such as market position, customer share and loyalty, brand strength, and supply chain strength drive those margins and expenses.
Figure 4-4 illustrates the strategic value chain. ROE, the result, is shown as a result or outcome at the right – hand side of the figure. Working backwards toward the left, the figure lists a few examples of value chain components that drive ROE components and thus ROE. Theyre grouped into strategic financials and strategic intangibles.
The value investor works backward through the ROE value chain to find good or bad in ROE drivers and the things that influence those drivers.For the first – tier components of ROE, perform a quality test. Look for characteristics that are off course. For example, low debt doesnt necessarily indicate high value, but frequent trips to the capital markets for debt or stock sales may indicate capital starvation and “un – value.” Consider a drug test metaphor here: The substances youre testing for are frequently addictive to bad managements – overuse of acquisitions, write – offs and write – downs, debt, and stock sales, which are used to pad numbers and fix problems arising from bad performance. Keep in mind that drug tests are usually painless pass/fail tests, not detailed assessments.
