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.
Now lets try to dig deep and understand the True ROE via DuPoint Analysis.
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
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)
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.
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.
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.
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.
Here equity multiplier value is around 2.0, meaning half of a company’s assets are financed by equity.
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.