Analyzing Illinois Tool Works' ROE

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Sep 25, 2014

In this article, let´s examine one of the most important financial ratios and the best measure of performance for a firm's management: the Return on Equity (ROE). We will analyze it in the case Illinois Tool Works Inc. (ITW, Financial)

ROE is calculated as net income applicable to common shares divided by the average book value of common equity: ROE = Net Income / Average Book Value

A higher ROE is viewed as a positive aspect for the company, but the reason behind it should be examined. From the equation above, we can see that if book value is decreasing more rapidly than net income, the ratio will increase, but this is not good for the firm.

Dupont Analysis

This approach can be used to analyze the ROE. With some algebra, we can break down ROE into a function of different ratios. Firstly, we are going to consider the original approach:

  • Original DupontEquation: Three-Part Dupont

Taking the ROE equation: ROE = net income / shareholder's equity and multiplying ROE by (revenue / revenue), and rearranging the terms, we get:

  • ROE = (net income / revenue) * (revenue / shareholder's equity)

We now have ROE broken into two parts: the first is net profit margin, and the second is the equity turnover ratio. Now we can expand this by multiplying these terms by (assets / assets), and when we rearrange the terms, we end up with the three-step DuPont equation.

  • ROE = (Net Income / Revenue) * (Revenue / Assets) * (Assets / Shareholder's Equity)

This equation for ROE breaks it into three widely-used and studied components:

ROE = (Net profit margin)* (Asset Turnover) * (Leverage ratio)

The first term is what we previously called the net profit margin, the second term is asset turnover, and the third term is a financial leverage ratio. If we have a low ROE, one of the following must be true:

  • The firm has a poor profit margin
  • The firm has a poor asset turnover
  • The firm has a little leverage
ROE (%) 3-Step dic-04 dic-05 dic-06 dic-07 dic-08 dic-09 dic-10 dic-11 dic-12 dic-13
Net Profit Margin 11.56 11.69 13.44 12.57 8.88 6.82 9.75 11.64 19.40 11.88
Asset Turnover 1.03 1.12 1.01 1.01 1.11 0.89 0.95 1.04 0.79 0.72
Leverage 1.49 1.52 1.54 1.67 2.00 1.82 1.72 1.79 1.82 2.04
ROE 17.27 19.70 20.74 20.36 17.86 11.50 16.54 21.36 27.89 16.57

Final Comment

As outlined in the article, a key ratio used to determine management efficiency is the ROE. In general, analysts consider ROE ratios in the 15-20% range as representing attractive levels for investment.

It is very important to understand this metric before investing and it is important to look at the trend in ROE over time. So let´s see the evolution on the next chart:

03May20171354001493837640.png

Over the past 13 years, the highest ROE was 27.89%, the lowest was 11.23% and the median was 18.75%. So based on this analysis, I would recommend investors to consider adding this stock to their long-term portfolios.

Hedge fund gurus have also been active in the company. Gurus like Ruane Cunniff (Trades, Portfolio), Joel Greenblatt (Trades, Portfolio) and John Keeley (Trades, Portfolio) added the stock in the second quarter of 2014, as well as Caxton Associates (Trades, Portfolio), Pioneer Investments (Trades, Portfolio), Manning & Napier Advisors, Inc and Diamond Hill Capital (Trades, Portfolio).

Disclosure: Omar Venerio holds no position in any stocks mentioned.