Method Isn't Always Most Telling Performance Measure.

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, 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.

                            Best 1-year Returns
                              Karen Teitelman
Rank Company                       Ticker  Return
                                   Symbol on Equity
  1  TELEDYNE TECHNOLOGIES INC.     TDY    110.1%
  2  NEWHALL LAND & FARMING         NHL     64.7
  3  GEMSTAR INTERNATIONAL
     GROUP [*]                      GMST    40.2
  4  KAISER VENTURES INC.           KRSC    39.5
  5  AMGEN INC.                     AMGN    36.3
  6  GUESS INC.                     GES     31.0
  7  K-SWISS INC.                   KSWS    30.6
  8  THQ INC.                       THQI    30.2
  9  SKECHERS U S A INC.            SKX     28.0
 10  AVERY DENNISON CORP.           AVY     26.6
 11  HI SHEAR TECHNOLOGY CORP. [*]  HSR     24.3
 12  GUITAR CENTER INC.             GTRC    24.1
 13  ELECTRONIC CLEARING HOUSE [*]  ECHO    23.4
 14  ON ASSIGNMENT INC.             ASGN    22.8
 15  WELLPOINT HEALTH NETWORK       WLP     22.6
 16  GBC BANCORP                    GBCB    22.5
 17  MERCURY AIR GROUP INC. [*]     MAX     22.5
 18  ALPHA TECHNOLOGIES GROUP
     INC. [*]                       ATGI    22.5
 19  EQUITY MARKETING INC.          EMAK    22.4
 20  XIRCOM INC. [*]                XIRC    22.2
 21  KAUFMAN & BROAD HOME
     CORP. [*]                      KBH     21.8
 22  MSC SOFTWARE CORP.             MNS     20.5
 23  SUPERIOR INDUSTRIES INTL.      SUP     20.1
 24  APEX MORTGAGE CAPITAL INC.     AXM     19.8
 25  VIRGO MANUFACTURING            VIR     19.8
                            Best 3-Year Returns
Rank Company                     Ticker  Return
                                 Symbol on Equity
  1  TICKETMASTER
     ONLINE-CITYSEARCH            TMCS   264.1%
  2  KORN FERRY INTERNATIONAL     KFY    169.0
  3  SKECHERS U S A INC.          SKX     71.8
  4  NEWHALL LAND & FARMING       NHL     46.6
  5  HILTON HOTELS CORP.          HLT     38.2
  6  GEMSTAR INTERNATIONAL GROUP  GMST    37.4
  7  GUITAR CENTER INC.           GTRC    37.1
  8  GUESS INC.                   GES     33.5
  9  AMGEN INC.                   AMGN    33.4
 10  THQ INC.                     THQI    27.7
 11  TIMES MIRROR CO.             TMC     27.2
 12  AVERY DENNISON CORP.         AVY     26.0
 13  HI SHEAR TECHNOLOGY CORP.    HSR     24.7
 14  TARRANT APPAREL GROUP        TAGS    23.2
 15  WELLPOINT HEALTH NETWORK     WLP     21.8
 16  ON ASSIGNMENT INC.           ASGN    21.4
 17  DUCOMMUN INC.                DCO     21.0
 18  JEFFERIES GROUP INC.         JEF     19.8
 19  GBC BANCORP                  GBCB    19.3
 20  KAUFMAN & BROAD HOME CORP.   KBH     19.0
 21  SUPERIOR INDUSTRIES INTL     SUP     18.7
 22  DAILY JOURNAL CORP.          DJCO    18.2
 23  SCOPE INDUSTRIES INC.        SCP     18.1
 24  FARR CO.                     FARC    17.9
 25  MERCURY GENERAL CORP.        MCY     17.9
                            Best 5-Year Returns
Rank Company                     Ticker  Return
                                 Symbol on Equity
  1  GUESS INC.                   GES    174.6%
  2  LEARNING TREE INTL. INC.     LTRE    51.7
  3  GEMSTAR INTERNATIONAL GROUP  GMST    47.5
  4  NEWHALL LAND & FARMING.      NHL     39.8
  5  SIGNATURE EYEWEAR INC.       SEYE    36.1
  6  AMGEN INC.                   AMGN    33.6
  7  HILTON HOTELS CORP.          HLT     26.7
  8  TARRANT APPAREL GROUP.       TAGS    24.9
  9  ALIGN-RITE
     INTERNATIONAL INC.           MASK    24.8
 10  CHAD THERAPEUTICS INC.       CTU     23.8
 11  AVERY DENNISON CORP.         AVY     23.3
 12  ON ASSIGNMENT INC.           ASGN    22.2
 13  THQ INC.                     THQI    21.6
 14  MSC SOFTWARE CORP.           MNS     21.1
 15  DAILY JOURNAL CORP.          DJCO    20.6
 16  DUCOMMUN INC.                DCO     20.2
 17  IMPCO TECHNOLOGIES INC.      IMCO    20.1
 18  WELLPOINT HEALTH NETWORK     WLP     19.9
 19  SUPERIOR INDUSTRIES INTL     SUP     19.6
 20  JEFFERIES GROUP INC.         JEF     19.4
 21  99 CENTS ONLY STORES         NDN     19.4
 22  MERCURY AIR GROUP INC.       MAX     19.1
 23  EQUITY MARKETING INC.        EMAK    18.2
 24  21ST CENTURY INS. GROUP       TW     18.0
 25  MERCURY GENERAL CORP.        MCY     17.2

Average return on equity is calculated by Duff & Phelps LLC using the average common equity for each particular time period. All decimals are rounded. Numbers that appear to be tied would not be if the numbers were carried out. Financial information on these lists has been provided by Duff & Phelps from sources deemed reliable. No recommendation is intended or implied. To the best of our knowledge, this information is accurate as of press time. While every effort is made to ensure the accuracy and thoroughness of this list, omissions and typographical errors sometimes occur. Please send corrections or additions on company letterhead to the Research Department, Los Angeles Business Journal, 5700 Wilshire Blvd., Suite 170, Los Angeles, 90036. (C)2000 Los Angeles Business Journal. This list may not be reprinted in whole or in part without prior written permission from the editor.

(*.)Most recent fiscal year not yet reported. Latest 12-month figure is represented.