DuPoint Analysis – The True ROE

Few days back in our Facebook group AIFW, we had a nice discussion on importance of ROE and one of the big heads in banking and financial services Mr. Balakrishnan R Balakrishnan Sir of Moneylife shared his views on it (He blogs at http://goo.gl/pJmOC6).

Following is the screen shot.

FB Comment

Now lets try to dig deep and understand the True ROE via DuPoint Analysis.

Introduction:

The name comes from the DuPoint Corporation that started using this formula in the 1920’s.

Investors use Return on Equity (ROE) to measure the earnings that a company generates from its assets / Equity. With it, one can determine whether a firm is a profit creator or a profit burner and management’s profit earning efficiency.
In the simple formula ROE can be calculated as

ROE = Net Income / Shareholders Equity

Why do we need DuPoint analysis ?

The DuPont method will enable you to unearth facts that are not so obvious, and so lead you to making more informed and better investment decisions.

Lets say by just looking at a company we may assume that, its ROE is increasing and we will have a good opinion created in our mind.

But what if, that increase in ROE happened because of Increasing DEBT ? 

If a company’s ROE goes up due to an increase in the net profit margin or asset turnover, it is a positive sign for the company. However, if the ROE is increasing due to equity multiplier, it may not be a good sign indicating that company ROE is increasing due to excess leverage. Here is where DuPoint analysis comes into place & helps us understand the better picture of the company.

This DuPont analysis examines RoE (Net Income / Shareholders Equity) through three components which are:

a) Operating efficiency, measured by profit margin (Net Profit/Sales)

b) Asset use efficiency, measured by total asset turnover (Sales/Total Assets)

c) Financial leverage, measured by the equity multiplier

Put in equation form,

RoE (Return on Equity) = (Net profit margin) * (Asset turnover) * (Equity multiplier) OR

RoE = Net Profit/ Equity = (Net Profit/ Sales) *(Sales/Total Assets) * (Total Assets/Equity)

Example - GlaxoSmithKline Consumer Healthcare Ltd

GSK

Lets take the example of GSK Consumer (the manufacturer of Horlicks, Boost etc) to understand the Dupoint analysis in better sense.

Calculating ROE using normal method (i.e Net Income / Shareholders Funds)

ROE_1

ROE_2

Three step Dupoint Model:

Net Profit Margin: The Net Profit margin of a company reflects management’s pricing strategy by showing how much
earnings they can generate form a single rupee of asset.

NPM_1

 

NPM_2

Asset Turnover ratio:

Asset turnover measures how much sales a company generates from each rupee of asset.
It helps us to measure management’s effectiveness in using assets to force sales.

ATR_1

 

ATR_2

But Krishna, How come a relatively good company GSK Consumer who is a darling of many have low asset turnover ratio ?

This is because, the majority of high margin companies (like Pharma, FMCG etc) also tends to have low asset turnover.
Any organization can only do a certain amount of business without incurring additional  costs that would surely impact profit margins. On the other hand, low margin organizations (like Capital Goods etc) tend to have high asset turnover as they rely on high sales volumes to generate profits.

Equity Multiplier:

The final component of the three step DuPoint model is Equity Multiplier, which helps us to examine how an organization uses debt to finance its assets. A higher equity multiplier indicates higher financial leverage, which means the company is relying more on debt to finance its assets.

FL_1

 

FL_2

Here equity multiplier value is around 2.0, meaning half of a company’s assets are financed by equity.

Findings:

1) We have seen that ROE of GSK Consumers have been increasing consistently over the past 5 years.
2) Net Income have also been increased during the years. GSK during the past 5 years was successful in converting the sales into Actual profits.

3) ROA of this company is inconsistent, meaning GSK is having some issues in utilizing its assets properly and convert them to Earnings.

4) By looking at the ROE and Financial Leverage numbers we can able to say that, the company have successfully increased ROE by not leveraging much, which is a good sign.

We also have 5 step method to calculate ROE, which considers (EBIT  + Sales) and Tax Efficiency of the company along with the 3 parameters used above. We will discuss as a continuation (Part-II) of this post.

Happy Diwali & Happy Investing :)

 

Disclaimer: The views and ideas discussed here and can be biased and do not act without proper analysis. 

Starting the cult of Indian Equity !!!

How did it all started in India and reached beyond Dalal Street ??

In this post let’s try to see how Equities have evolved in India and reached retail investors.

Even though Stock exchanges were in place from more than 4 centuries (Amsterdam Stock Exchange being the old stock exchange founded in 1602),

In India stock operations have started in the mid of 18th century. It was actually during the mid of 1970 that BSE had started its Index (Sensex with base value of 100 consists of 30 stocks) when it all started.

The late 1970s witnessed the start if the equity cult in the Indian stock markets. During those times, textile was a hot sector and the industry ad a weightage of over 20% in the BSE Sensex.

Reliance Industries entered the capital market in the late 1970s and with its state of art ultra modern facilities was about to change the rules of the game. And it did so. The public issue came with such fan fare. The company had a spectacular rise with a huge following the retail investors. Mr. Dhirubhai Ambani used to conduct his AGM meetings in cricket grounds.

dhirubhai-ambani

Please watch this below video clip of movie “Guru” to understand it.

 

 

He was the man who set the equity cult in India by being very investor friendly and handsomely rewarding his shareholders.

 

During those days the Foreign Exchange Regulation was enacted and all foreign companies were asked to either list their

shares on Indian bourses or quit India. Some companies like Hindustan Lever (HLL), Nestle, Colgate obliged but others like Coca Cola quit.

 

This was the begining of a new era in Equity investing and all these companies that got listed are called asked

“FERA” (Foreign Exchange Regulation Act) companies. They soon became the stock market favourites and almost all of them

commanded a high PE valuations. Indians for the first time got an opportunity to invest in foreign owned companies.

 

The then Big Daddy “Controller of Capital Issues” controlled the pricing of IPO from Indian shareholders getting them at ridiculous valuations (which was not the case these days)

 

For example, HLL was “FORCED” to offer its price at Rs.16 (FV of 10 at a premium of 6). These kind of companies made a lot of wealth

for the Indian shareholders. Infact Ace and old value investor Mr. Chandrakanth Sampath made all this fortune from consumer goods.

 

Chandrakant-Sampat-190

Read more about him here.

 

With the success of these IPO’s we have seen many international companies entering into Indian capital markets.

Investing was once meant for few business houses or few individuals, slowly at that time it moved towards retial investors.

Many companies like Xerox, Tektroniz, Wartsila, ZF steeting, Gillete etc entered Indian markets.

 

Foreign companies like engineering gaint Siemens and pharmaceutical innovator Glaxo was listed and were able to get ideas and technology from their parents. They were considered as Future growth stories. Glaxo commanded 3.21% weightage in index and HLL at 7.92%.

The First Index composition of India !!!

Index composition

 

Industrial icons of India “Tata” & Birla groups have immense respect among investors which also translated into their companies weightage in the index. In the later post, we will discuss how these companies performed in Long run, if we have bought them “just because those were Index Stocks”. Till then, Happy learning and Investing :)

 

Sources & References

http://www.bseindia.com

http://www.wikipedia.com

Stocks to Riches by Parag Parikh

Motila Oswal wealth reports

Equity Valuation using Dividend Discount Model. Example: Coal India & VST Industries !!!

As part of our learning in Equity Valuations, we understood how to value cyclical companies,  NBFC’s and Banks, using PE multiples and how to use Discounted Cash Flow method to find intrinsic value. Now let’s try to use Dividend Discount Model to value a company.

“A cow for her milk, a hen for her eggs, and a stock, by heck for her dividends.” – John Burr Williams, The Theory of Investment Value, 1938.

In the strictest sense, the only cash flow you receive from a firm when you buy a stock is the dividend. The simplest model for valuing equity is the dividend discount model. It is nothing but the value of a stock is the present value of expected dividends on it. While many analysts have turned away from the dividend discount model and viewed it as outdated and mostly use DCF, there are still many specific companies where the dividend discount model remains a useful took for estimating value. (Continue reading…)

“Markets: The Slave of Earnings !!!” -Case Study: Eicher Motors & Page Industries.

Let me start this post by quoting Munger & Buffett quotes on Earnings potential.

 

“Over the long term, it’s hard for a stock to earn a much better return than the business

which underlies it earns. If the business earns 6% on capital over forty years and you hold

it for that forty years, you’re not going to make much different than 6% return – even if

you originally buy it at a huge discount. Conversely, if a business earns 18% on capital

over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with one hell

of a result.”

- Charlie Munger, Vice-Chairman, Berkshire Hathaway (Continue reading…)

How to value cyclical companies ?

Starting from this, I want to make a series of posts on different valuation techniques we use to value the companies like,

1) Young companies
2) Growth companies
3) Mature companies
4) Cyclical companies
5) Commodity based companies
6) Declying companies etc

In my previous post I have already discussed, how differently we value Financial firms.

In this post, I am going to discuss on how to value cyclical company by taking Maruthi Suzuki as example.

Uncertainty and volatility are endemic to valuation, but cyclical and commodity companies have volatility thrust upon them by external factors. As a consequence, even mature companies have volatile earnings and cash flows.

It is always a challenge to value companies that have volatile earnings. (Continue reading…)

My Best friend named “Emergency Fund” !!!

My own experience:

1) 20 days back, I got a call from home. Summary of that call is to arrange 1 Lac in 2 days.
– Done. Thanks to Emergency fund.

2) 5 days later, an unexpected and unstoppable expense of 60k.
– Done. Again thanks to Emergency fund.

3) Exactly 4 days later, Mother hospitalized (She is Fine now!) because of existing disease which is not covered by my Oriental Family floater.
– Handled it as well. Again thanks to Emergency fund.
(Continue reading…)

Remembering my Investing Gurus !!!

On this occasion of Guru Purnima, I take this opportunity to thank all my Investment Gurus who taught me (and their is lot more yet to learn) and stood like a Light house in my Investment Journey.

In the investment world, some people think it is “cool” to say “I am a Value Investor”. But it is not so cool to follow it. Not at all. Infact it is a mindset that should be incorporated in the life style itself and not only in Investment related decisions.

One person who is the dean of Value Investing is “Ben Graham”. (Continue reading…)