Understanding ROE (Part 3)

Today I want to return to Part 1 and give a couple examples using DuPont analysis (equation [1]).

Net profit margin, the first term, is calculated as follows. Top line of an income statement is revenue (i.e. sales). Subtract from that expenses such as SG&A (selling, general, and administrative costs), COGS (cost of goods sold) and other line items to get net income before taxes (i.e. pre-tax profit). Every income statement labels things differently but a general example is Item 8 here. Subtract taxes from pre-tax profit to get net income (i.e. profit). Divide profit by revenue and multiply by 100% to get profit margin (as a percentage).

The importance of net profit margin is clear, then. All else being equal, increasing profit margin will proportionally increase ROE. For example, if ROE is 12% and net profit margin is 6%, then increasing net profit margin to 10% will increase ROE to 20%. The same can be said for the second [asset turnover ratio] and third [financial leverage] terms.

Studying asset turnover ratio helps us understand the efficiency of asset use to generate sales. Higher ratio is better and means the company is less asset intensive. Assets can include stores, acquisitions, products, and markets. The key point to investigate is whether company is investing in new assets to grow future sales.

The financial leverage ratio reflects how well the company is using debt (borrowed money) to finance asset purchase to grow sales and earnings. Assets should increase future sales and earnings more than the cost of borrowing (i.e. interest).

Studying return on assets (ROA) rather than ROE can sometimes be advantageous. This shifts the focus from shareholder returns to operational efficiency, debt usage, and asset management. ROE measures how much profit a company makes with shareholders’ capital whereas ROA indicates how effectively management uses debt and equity to generate profit.

One big advantage of ROA over ROE is independence from financial leverage (debt). As mentioned in the Part 1 penultimate paragraph, higher leverage can boost ROE. ROA is less affected by a company’s capital structure. High ROE can make a company look profitable in these cases whereas its ROA can still reveal its assets are not generating high returns.

Stated another way, high ROE with low ROA indicates that a company is using high leverage to boost returns, which is riskier. ROA is superior for evaluating management’s ability to manage assets regardless of how those assets are financed.

ROA is best for asset-heavy industries. This includes industries with substantial capital investments such as utilities, telecommunications, and manufacturing.

ROA (or ROAA: return on average assets) is preferred when studying the banking sector to measure asset utilization and operational efficiency. Anything over 1.00% (1.25%) may be considered good (excellent).

I will continue next time.