In this article, let´s see one of the most important financial ratios applying to stockholders, the best measure of performance for a firm's management: the Return on Equity (ROE), and we are going to analyze it in the case of Altria Group Inc. (MO, Financial), a $93.34 billion market cap company, which is the largest U.S. cigarette producer with roughly 50% share.
Long-term drivers
It's no surprise that cigarettes are the primary driver of Altria's earnings. Marlboro is the dominant cigarette brand in the U.S. The major reason is the quality that Marlboro cigarettes offers to smokers.
However, cigarette consumption could decline in the next several years, due to health concerns and strict marketing restrictions; the firm must impose its pricing power to offset the decline.
In the next 10 years, it is probable that Altria will be selling fewer cigarettes because of health concerns and strict marketing restrictions. We believe its smokeless tobacco business is likely to increase during the next decade.
Dividend policy
Since 1928, Altria has had an attractive dividend policy showing its commitment to return cash to investors in the form of dividends as it generates healthy cash flow on a regular basis. The current dividend yield is 4.6%, which is very good to protect the purchasing power, especially considering the consistency of track-record dividends payments and favorable expectations regarding dividend growth and share repurchases. Management announced a new $1 billion share-repurchase program, to be completed by the end of 2015.
Return on Equity
Now, we are turning our attention to the calculus of our preferred metric –Â ROE, which is calculated as net income applicable to common shares divided by the average book value of common equity: ROE = Net Income / Av. 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. First, we are going to consider the original approach:
Original DuPont equation: Three-part DuPont
Taking the ROE equation: ROE = net income / shareholder's equity and multiplying ROE by (revenue / revenue), and rearranging 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 rearranging 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 called previously net profit margin, the second term is asset turnover and the third tem 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
Extended DuPont analysis: Five-step DuPont
Net Profit Margin = Net Income / Revenues can be rewritten using another mathematical identity:
Profit Margin = (Net Income / Earnings Before Taxes) * (Earnings Before Taxes (EBT) / Earnings Before Interest and Taxes (EBIT)) * (EBIT / Revenues)
Tax Burden = (Net Income / Earnings Before Taxes): is an indication of how much the company is paying in corporate taxes, or how much of the profit is falling to the bottom line.
Interest Burden = (Earnings Before Taxes / Earnings Before Interest and Taxes)
Sales Margin = (EBIT / Revenues): is another way of looking at how profitable each dollar of revenue is after deducting operating expenses but before deducting interest and taxes.
Net Profit Margin = Tax Burden * Interest Burden * Sales Margin
And finally, the complete Extended DuPont Analysis:
ROE = (Net Income / EBT) * (EBT / EBIT) * (EBIT / Sales) * (Sales / Assets) * (Assets / Equity)
ROE = Tax Burden * Interest Burden * Sales Margin * Asset Turnover * Equity Multiplier
Final comment
This industry faces strict anti-smoking regulation, taxation and high barriers to entry which make it attractive for well-known brands. Further, the tobacco portfolio and e-cigarettes give the firm economies of scope and scale that make it difficult for new entrants to compete.
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. As we can appreciate, in all of the years the firm reaches those acceptable levels according to what we have just said.
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:
During the past 13 years, the highest Return on Equity (ROE) was 124.47%, the lowest was 23.90% and the median was 46.11%. So based on this analysis, I would recommend investors consider adding this stock to their long-term portfolios.
Although the industry has strong competition and the business is relatively stable, I would recommend fundamental investors to consider this attractive option for their long-term portfolios.
Hedge fund gurus Bruce Berkowitz (Trades, Portfolio), Jim Simons (Trades, Portfolio), Ken Fisher (Trades, Portfolio), Sarah Ketterer (Trades, Portfolio), James Barrow (Trades, Portfolio) and Murray Stahl (Trades, Portfolio) added the stock in the second quarter of 2014, as well as Pioneer Investments (Trades, Portfolio).
Disclosure: Omar Venerio holds no position in any stocks mentioned.
