From the common shareholder’s point of view, profitability ratios such as Return on Assets and Return on Equity are the best possible way how to gauge success of an enterprise and its management. Return on Equity literally measures percentage profit for common shareholders in relation to the invested capital, or how much investors as a group are receiving back on annual basis from their initial investment in a particular company[1]. This article discusses three different components of this RoE metric on a risk-adjusted basis and hence three different strategies how companies usually deliver returns to their shareholders.
A simple algebraic equation known as DuPont decomposition identifies the following drivers of Return on Equity ratio:
Return on equity = Profit Margin x Assets Turnover x Leverage
also written as:
NI/E = NI/S x S/A x A/E
Profit margin
Profit margin is one of the most important measurements of superiority of one business over others. It reflects a company’s competitive position among peers and stability of its earnings in relation to the volume of business performed. Profit margin is the most desirable way company management can improve return on equity and bring value to shareholders by fostering its competitive powers via brand development, economies of scale, cost reduction, capital requirements and others.
To illustrate how ample profit margin can stabilize earnings of an enterprise, please consider two companies named “The Big A” and “Little B,” operating within same industry and with identical earnings of $1,000,000 and revenues of $20,000,000 and $10,000,000, respectively. Let’s assume that at least some portion of the expenses is fixed and therefore sales independent (e.g., staff salaries). Given all other factors are equal, are earnings coming from the bigger company better? Not necessarily. Although the first company has bigger revenues, its lower profit margin makes earnings more volatile in response to the percentage changes in volume of these revenues.
Asset turnover
Asset turnover is one of the activity ratios that gauges how quickly business utilizes assets at its disposal in order to generate sales. We won’t give any special consideration to this ratio for the purpose of our risk-adjusted analysis, assuming that two businesses that exhibit different levels or return on equity due to varying amounts of sales per dollar of assets are priced proportionally.
Leverage
Leverage or Assets-to-equity ratio is not a preferred source of achieving RoE because it may mean that management is taking additional risks for which shareholders may not be necessarily compensated. Exuberant leverage is naĂŻve and in many cases also the wrong way for management to improve reported returns on equity without need of being innovative or competitive. This applies to both additional debt issuance and share repurchases.
Boosted enterprise profits due to undue corporate debt in good times is a double-edged sword, often in principle very similar to capital gains on private investor’s leveraged brokerage account. In both cases, results are unrelated to the competitive positions of the enterprise or skillfulness of its management.
Moreover, interests of management are often misaligned to those of shareholders. Asymmetric compensations such as stock options further exaggerate problems associated with leverage and excessive risk taking.
From the shareholders’ point of view, capital leverage with associated fixed interest charges on income statement is major factor which contributes to undesired volatility of earnings in response to varying volume of revenues. Therefore, although both leverage and profit margin contribute to the company earnings in same direction, they bring exactly opposite effect in terms of stability of these earnings. Higher profit margin implies more stable returns to equity holders; while higher leverage destabilizes these returns.
The risk factor
Ignoring the risk factor, all three previously mentioned metrics used in DuPont decomposition contribute to return on equity linearly, as expressed by the algebraic equation above. However, on a risk-adjusted basis and for the reasons already stated, profit margin also brings additional value, not expressed in this equation, in a form of increased stability of earnings. We can therefore refer to it as “the convex metric.”
Similarly, inadequate leverage jeopardizes stability of these earnings and therefore is better to be avoided. This can be thought of as a negative contribution to the risk-adjusted value, which leads to its concave shape, as illustrated in the chart below:
If we draw population of all companies within a single industry onto a two-dimensional space with dimensions being profit margin and leverage, we can clearly assess businesses with respect to the amount of risk adjustment (a.k.a. quality) of their RoE. Higher profit margin and lower leverage implies that business has potential to achieve returns which are more stable and therefore of higher quality.
Industry-specific characteristics of DuPont equation
It is important to highlight that all compared companies must be within the same industry. The comparison of businesses across different industries is often meaningless and misleading. Different industries are driven by different forces and these forces broadly define boundaries for each of the factors in DuPont equation. For example, discount stores may afford below-average profitability ratios thanks to above-average asset turnovers. Such low profitability ratios would be unsustainable, for example, for a company from the technology sector.
The real-market-data version of the schematic diagram above shows where most of the publicly traded U.S. equity stands in terms of their profitability and leverage, with a couple of examples highlighted. We will illustrate why it is important not to mix ratios from DuPont equation across different industries together.
(Source: www.finviz.com)
Visa and MasterCard
The returns on equity of these two companies possess above-average quality thanks to low indebtedness and high profit margins. The profit margin in both cases exceeds 40% which is outstanding even for Financial Services industry. Visa (V, Financial) has almost no debt at all.
In general, credit-services companies can afford hefty profit margins thanks to the oligopolistic industry in which they operate in; and considerable barriers imposed on new entrants. They operate almost like unregulated toll bridges with substantial freedom to raise transaction charges and earn superior profits.
Software companies like Google (GOOG, Financial)(GOOGL, Financial) or Facebook (FB, Financial) often enjoy ample double-digit profit margins as well, mostly due to focus on intellectual property and high barriers of entry for new entrants. However, Facebook in our opinion is a typical example of cases in which high profit margin doesn’t protect company earnings against fundamental changes in competitive position of the underlying business. It’s often the technological progress which makes technological companies obsolete and brings them to their knees. History is full of imploded examples such as MySpace, Psion, Kodak or RIM.
From the perspective of leverage, Facebook has no long-term debt and relies entirely on shareholders' money to support growth which they are striving to achieve. The fact that they are not paying any dividends raises questions about appropriateness of their capital structure backing this growth. This is another example where financial ratios shouldn’t be interpreted purely on mathematical basis without further fundamental analysis.
Coca-Cola
Coca-Cola (KO, Financial) owes its high profit margin of 15% against the industry average 5.5% and its biggest rival PepsiCo’s (PEP, Financial) 10% to strong brand identity, vertical integration and economies of scale. The company is operating steadily since 1886, with continuously increasing dividends since 1986. Such impressive history together with realized stability of earnings over multiple years makes its own point against for instance much younger company – the Facebook, which has almost no debt and profit margin of double the size of the Coca-Cola’s.
Conclusion
This article illustrates that while Return on Equity is the most important and universal measure applicable to almost any company in any industry, the factors driving it are industry specific and not directly comparable.
While different industries may have different weightings of DuPont factors, it is universal that profit margin is generally a positive driver while leverage has more of a negative reputation.
This article also presents handful of examples where investors need to consider also qualitative aspects of a business which may sometimes contradict quantitative measures discussed here.
[1] Assuming stable company size and price level, depreciations equal to capital expenditures and shares purchased at par.
