ShawnRobinson (40.93)

What's behind the declining ROE at Morningstar?

November 22, 2011 – Comments (1) | RELATED TICKERS: MORN

Investors should learn to calculate a stock’s Return on Equity (ROE) to properly gauge how effective management is in generating return for investors. For those who don’t know what ROE is, here are a few, well put together tutorials on the subject:

http://www.fool.com/investing/beginning/return-on-equity-an-introduction.aspx
http://beginnersinvest.about.com/od/incomestatementanalysis/a/understanding-return-on-equity.htm

The ROE metric, described in percentage terms, is most useful when comparing to previous fiscal years to demonstrate trends. These trends, with a little research, can highlight the actions management is taking to create or destroy shareholder value. For example, examining the ROE trend for Morningstar ($MORN), the financial services firm that creates the ubiquitous Morningstar mutual fund rating system, you will notice a downward trend of ROE over past number of years. It’s logical to think that maybe the recent recession put downward pressure on the business. But MORN’s closet competitor, Factset Research Systems ($FDS), seems to have been growing ROE over the same period (see link for chart below). So what’s happened to Morningstar?

http://shadyoakresearch.com/home/wp-content/uploads/2011/11/MORN-ROE.jpg

Looking at the ROE equation, Net Income (NI) divided by Shareholders Equity (SE), there could only be changes in two factors that correlate to a drop in ROE. Let’s first look at Net Income. MORN’s net income appears to be growing or at the very least staying steady over the same period.

http://shadyoakresearch.com/home/wp-content/uploads/2011/11/MORN-NI.jpg

What about Shareholders Equity?

http://shadyoakresearch.com/home/wp-content/uploads/2011/11/MORN-SE.jpg

Shareholders equity is our culprit as it appears to be rising faster than net income. Understanding SE as assets minus liabilities, we can compare the line items in each category over time to see if any are growing or declining (in case of liabilities) rapidly. Liabilities seem to be holding steady which turns me to assets. Bingo. Other factors have led to the increase in assets but the Goodwill and Intangibles line items appear to have shown the most rapid growth since 2007.

http://shadyoakresearch.com/home/wp-content/uploads/2011/11/MORN-Goodwill.jpg

Goodwill is an accounting term for the value paid by the acquirer above the market value of the asset. For example, acquiring a company for $100 per share that has a market value of $100 million (1 million shares outstanding), for $120 per share, resulting in a payment of $120 million, the $20 million is classified as Goodwill. Intangibles assets are value held for patents, brands or other “intangibles” that are hard to quantify. Looking at the past few 10-k’s, MORN has certainly made many acquisitions that increased their Goodwill/Intangible position. Here are a few of the 15 or so acquisitions and their increase in Goodwill and Intangibles (from the 10-k’s):

2007 – S&P 500 Fund Data – $70 million
2008 – Hemscott Data – $55 million
2008 – Tenfore Systems – $22 million
2009 – Acquisition of Logical Information Machines, Inc. – $57 million
2010 – Acquisition of Old Broad Street Research, Ltd. – $22 million
2010 – Acquisition of Realpoint, LLC – $43 million
2010 – Morningstar Denmark – $21 million

Keen investors have to ask whether it’s really a bad thing to see such an increase in Goodwill/Intangibles. The answer to seemingly everything is that it depends. It depends on how much value management can create from the acquisition to overcome to premium paid for the asset. If the acquisition fails to realize synergies expected, then management is wasting cash or diluting existing shareholders stake in the company unnecessarily. But if the asset creates value, even if it is a few years past the acquisition date, then shareholders should welcome the temporarily lapse in ROE.


I started this article stating that an important element of looking at ROE trends is to research why the ROE is trending the way it is. The research has led me to monitoring MORN’s management team on their effectiveness of acquisitions, which is a crucial element in creating shareholder value. I recommend researching ROE trends to see what good tidbits on management’s methods to create or destroy shareholder value you can come up with.

Please feel free to contact me at contact@shadyoakresearch.com