Last year Hilton Hotels Corp. was the most profitable public company in Los Angeles, based on return on equity. But this year it’s nowhere to be found on the list.

Which just goes to show that a company can be king of the ROE hill one year, and the next it can tumble to the bottom of the heap.

Does it matter? While many investors rely on return on equity as a strong indicator of company performance, analysts say it’s not the ultimate measurement by which to judge a company.

ROE is a percentage calculated by dividing net income into common shareholder equity. It is boosted by an increase in net income. But net income can be artificially inflated by one-time gains or other factors that have little to do with a true improvement in company performance.

Likewise, ROE can be boosted by reducing common shareholder equity by employing such tactics as issuing debt or buying back shares. Debt can ramp up when one company acquires another, or spends money on research and development projects that may not pay off for several years. Over the long run, these can be very profitable investments, even if they damage ROE in the short term.

The fate of Hilton

“Companies often have to borrow money to make an acquisition, which adds to their equity base but doesn’t produce net income right away,” said Brett Hendrickson, director of research for the Westside brokerage B. Riley & Co.

That’s what happened to Hilton. Last year, the Beverly Hills-based hotelier acquired Promus Hotel Corp. in a $3 billion deal. That brought Hilton an additional 1,400 hotels to own or operate, under such brands as Doubletree, Embassy Suites, Hampton Inn and Red Lion.

Analysts said the deal gives Hilton a steady earnings stream and avenues for future growth. But it didn’t help its return on equity last year because the acquisition costs dragged down shareholders’ equity.

Yet Hilton is still on the list of public companies with the best three-year and five-year return on equity in L.A. County (see facing page).

The same dilemma dogged Natrol Inc., No. 2 on last year’s list of most profitable public L.A. companies. For 1999, it fell off the ROE scale because the Chatsworth-based manufacturer of dietary supplements purchased Prolab Nutrition Inc. of Bloomfield, Conn., for $29 million in cash and 124,270 shares of common stock. Prolab markets sports-nutrition products for body builders.

So if return on equity isn’t the most accurate barometer of a company’s health, what is?

Investors such as John Lee, president of Century City-based Hollister Asset Management, prefer to look at net margin, which is net income as a percentage of sales. He also analyzes return on retained capital. “These two major indicators are far more indicative of what a business is doing,” he said. “Before the era of creative financing, return on equity might have been a more effective way of looking at a company. But now it’s not that clear cut.”

Frank Baxter, chairman of the Jefferies Group Inc., a Los Angeles-based investment company, thinks return on equity isn’t a bad measurement, but it is wiser to look at a number of financial indicators. “There is no one gauge. You have to have an entire instrument panel to judge a company,” he explained.

For example, the Jefferies Group was on last year’s lineup of most profitable L.A. public companies. It slipped off the list this year mainly because it spun off its electronic stock-trading unit, Investment Technology Group Inc., into a separate company in 1998.

“One of the things we’re trying to do is get back on the list,” Baxter said.

Success over the long haul

While ROE isn’t always the best gauge of a company’s health, it can help give investors a clue. For example, K-Swiss Inc., a Westlake Village company that makes athletic shoes and apparel, made it on the list for the first time in recent years. Last year its net income grew 175 percent to $34 million. Sales last year grew 77 percent to $285 million.

While some companies make it to the list just once, a better indicator is whether a company’s return on equity is consistently good, like that of Guess Inc.

The Los Angeles company that started out manufacturing designer jeans has expanded to offer accessories and upscale apparel. It is among the few L.A. companies that have generated a good one-, three- and five-year return on equity. Last year its net income grew 107 percent to $51 million.

“That doesn’t surprise me,” said Hendrickson of B. Riley & Co. “They have done a good job of licensing their brand name. That money just flows straight to the bottom line, and there is little capital investment.”

Thinking Behind Most Profitable List

Though there are a wide variety of ways to measure company performance, return on equity is one of the most popular, and perhaps the most revealing.

Return on equity measures the profit a company earns for every dollar that holders of common stock have invested. It is calculated by dividing annual net income by shareholder equity a company’s assets minus liabilities.

Some formulas calculate an average value for shareholder equity using numbers from throughout the year. The Business Journal calculated shareholder equity based on assets and debts at the end of 1999. That’s why some companies, such as Teledyne Technologies the No. 1-rated public company in Los Angeles County in terms of return on equity show up on the list even though it didn’t exist as an independent public entity for most of 1999. Teledyne was spun off from Allegheny Technologies last November.

Because one-year return on equity only provides a limited picture of a company’s overall success, the Business Journal also has included three-year and five-year ROE lists (see page 19). Longer time frames often provide a more-accurate gauge of a company’s long-term performance.

Of course, return on equity sometimes has little to do with the way Wall Street values public companies. Typically, investors are more interested in a company’s future performance than its most-recent results. We also take a look at L.A. County’s top stock performers last year on page 23.

The information in this special report was compiled by the Los Angeles office of Duff & Phelps, which used a variety of data-gathering services. Working on the project were senior analyst Marissa Jaramillo and associate Andrey Kalashnikov. It was overseen by Greg Range, Duff & Phelps’ managing director.

When possible, financial data are for the year ended Dec. 31, 1999. In some cases, a company’s reported fiscal year ended earlier, and that data is used in those instances. In cases in which a company’s most-recent reported data is for 1998, Duff & Phelps used the four most recently reported quarters.