The new ROE?

Lately I’ve been giving a lot of thought to topics of environmental systems and sustainability policy for consulting work and somehow this idea from Corporate Finance class with Professor Jacque resurfaced.  (For additional context, I was reading an interesting guide on “Decoupling Indicators” published by OECD, OECD_Decoupling.)

A useful technique for better understanding the underlying drivers of a firm’s past performance is to decompose Return on Equity (Income / Equity or “ROE”) into three components: Profit, Asset Utilization, and Leverage. The decomposition is insightful as the components reflect three basic functions in a firm: marketing, operations and finance, respectively.  As a formula, it looks like this:

Income / Equity = (Income / Sales) * (Sales / Assets) * (Assets / Equity)

Okay, so why the heck did this occur to me, besides that I might be a huge nerd and/or one of the few paying attention in lecture?  Well, what if we think of Net Exports as our flow variable (replacing Income) and Cumulative Environmental Impact as our stock (replacing Equity)?  Decomposing Net Exports / Cum Env Impact could involve some of the central elements of sustainability strategy, namely: (1) global markets, (2) productive people, (3) frugal behavior and (4) clean technology.  It could look something like this:

Net Exports / Cum Env Impact = (Net Exports / GDP) * (GDP / Population) * (Population / Consumption) * (Consumption / Cum Env Impact)

This could be one way of quantifying and decomposing a measure of Sustainable Environmental Economic Development (SEED?).  When I look at this formula (that I sketched on a napkin) my immediate reaction is that the best way to maximize the left-hand-side is to invest in knowledge-based, clean technology sectors in order to serve international markets, while promoting social responsibility and educating the next generation about the risks facing our planet and the opportunities for entrepreneurship.  That sounds about right, but maybe there’s a better formula out there(?)

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