In previous sections of chapter five in the book, "Strategic Value Investing: Practical Techniques of Leading Value Investors," the authors directed readers on how to study financial statements. Stephen Horan, Robert R. Johnson and Thomas Robinson showed that value investors would find relevant and insightful data in the income statement, cash flow statement and balance sheet.
The authors went on to show how key data from those statements could be combined into ratios, which is to say, helpful summaries of data. Now, in the next section of the chapter, which addresses the analysis of companies, they proposed to integrate some of the ratios for even more insight.
They were referring to what’s known as DuPont analysis, or decomposition of return on equity. In the opening paragraph, they laid it out this way (I have separated the sentences to make it easier to read):
- “The overall return to equity holders is a function of operating profitability, efficiency, leverage, and taxes."
- “The relationship of ratios reflecting these components can be linked algebraically to return on equity."
- “In this section, we first examine the relationship of ROE to ROA and leverage.”
To begin, we note the difference between ROE and return on assets. ROE is based only on the amount of shareholder capital (equity) injected into the company, while ROA considers all sources of capital, including borrowed cash (leverage).
Thus, if a company operates only on equity from shareholders, ROE and ROA will be the same. But if the company begins borrowing, then ROE and ROA will diverge. The authors provide the example of a company that has pre-tax, pre-interest (earnings before interest and taxes) return on assets of 9%. With only equity financing, it had ROA (net of interest and taxes) of 6.3% and ROE of 6.3%.
Next, the company borrowed money at 8% annually—less than the ROA of 9%--and now it has ROA (net) of 3.5% and ROE of 7%. Because of interest expenses that show up on the after-tax return, ROA (Ebit) has declined to 3.5%.
At the same time, ROE has jumped to 7%. The authors explained, “The company was able to borrow at 8 percent pretax and invest these funds in the business at 9 percent pretax.” They added that the additional value gained accrues to shareholders, pushing up the ROE.
Put another way, shareholders were able to bring new financing into the company without diluting the value of the existing shares. This extra financing requires the payment of interest, which reduces ROA, and by gaining new resources will make the company more profitable, which pushes up ROE.
Of course, all of that assumes the company can borrow money for less than ROA on an Ebit basis. The authors’ example shows that if the company borrowed at 10% (more than the ROA of 9%), then ROA would drop to 2.8% and ROE would fall to 5.6%. In this case, the company is losing money because it is paying more for its borrowed cash than the borrowed cash can generate in new business.
This equation from the book shows the relationship among ROE, ROA and leverage:
This is what the authors referred to as the “decomposition of ROE.” ROE has two components: ROA and leverage (debt); any change in either ROA or leverage will have an effect on ROE.
The authors remind us that while leverage might be considered a positive element, it does affect ROA because of added interest costs. As the old saying goes, leverage is a “double-edged sword.” So long as the cost of borrowing is less than the new profit it brings in, it’s a good thing. But if the opposite turns out to the case, then it’s a bad thing.
ROA also can be decomposed into profit margin and turnover (also called efficiency):
Here we see that ROA is a function of profitability and efficiency. Good management can improve both profitability and efficiency, so management is also the driver of ROA.
Decomposing another step, and substituting profitability and efficiency for ROA, the authors reported that “ROE is the product of profitability, efficiency, and leverage”:
Finally, they decompose ROE once more, again based on the factors that have emerged in previous decompositions:
The authors wrote, “From this decomposition we can see that there are five primary factors impacting ROE: the impact of taxes, the cost of financing, operating profitability, efficiency, and leverage. This breakdown enables you to examine which of these factors are driving ROE, both over time and in comparison to peer companies.”
To that, I would add these formulas provide a reading guide for quarterly reports, annual reports and management discussion and analysis sections. Look for any references to these words and phrases:
- Operating profitability.
- Efficiency.
- Leverage.
- The impact of taxes.
- The cost of financing.
Is management promising to improve any or all of these factors, have they delivered on promises of improvements made in the past or do they have a strategic plan for improvements in these areas? Along with the allocation of resources, these are essential areas on which management should be judged.
Conclusion
For value investors looking for an analytical framework, the ideas about ratios in this section provide a good starting point. Assessments of ROE, ROA and leverage, using the formulas in this section of chapter five, promise a focused pursuit on the issues that matter to investors. Return on equity is what all investors want from their investments, and the authors have shown us where to look for information about potential returns.
Read more here:
- Strategic Value Investing: Company Analysis, Part 3
- Strategic Value Investing: Company Analysis, Part 2
- Strategic Value Investing: Company Analysis, Part 1
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