- Return on equity arises from profitability, efficiency and leverage
- Understand when debt becomes a drag
Return on equity (ROE), calculated by dividing net income by average total equity, isn’t a flawless method of measuring company performance. But dig deeper and it provides important clues. One method of analysing the factors that contribute to overall ROE is via a Dupont analysis, which breaks down ROE as a function of profitability, efficiency and leverage.
Viewed in isolation, ROE usefulness is limited by the fact that it can be bolstered by companies taking on debt (by assuming equity is the only capital put to work, the formulation flatters the returns produced). In most cases, it is preferable to look at return on capital employed (ROCE) or, even better, returns on invested capital (ROIC), both of which consider returns on firms’ entire capital structures.
When building a watchlist of quality shares, companies’ ROCE and ROIC track records are important. Yet in tough times such as the current moment, there are few guarantees that good past performance will be repeated. Therefore, it is worth deconstructing the inferior ROE metric because of what it can tell us about the general health of a business.
Once such a health check has been undertaken, would-be investors can shift their attention to valuations, and consider what would be an attractive entry point for, say, quality shares that rarely become cheap.
Dupont analysis: the decomposition of return on equity
Dupont analysis can break down ROE into two, three or five components. The first and simplest iteration illustrates ROE as a function of a company’s return on assets (ROA) – a measure of operating performance – multiplied by the financial leverage ratio:
ROA is net income divided by average total assets, while the leverage ratio is average total assets divided by average shareholders’ equity. What’s clear from the equation above is companies can improve their ROE through superior operating performance or by taking on more debt. When analysing trends in a company’s ROE, understanding which of these factors has the greatest sway is an important indicator of the quality of a business.
The contrast between firms that have grown through operational efficiency and those that have grown through leverage will prove stark in a harsh economic environment. With net income under pressure as recession hits revenues and rising costs bite into gross margins, rising interest rates create a significant headache for indebted businesses.
Leverage only increases ROE so long as margins outstrip the cost of borrowing. With the former under downward pressure and the latter on the rise, return on assets will be depressed, too. Therefore, when building their watchlist, investors must be wary of indebted firms: they may find the quality indicator of good past ROE crumbles all too easily.
Going a step further, the three-step Dupont analysis expresses ROE as a function of profitability (the net profit margin), operational efficiency (the asset turnover), and the leverage employed.
The return on assets used in the two-way Dupont analysis is a function of the profitability and efficiency of operations which make up the first two parts of this equation. But there is important information to be gleaned from the more granular approach. Profitability is a simple-to-understand cornerstone of quality companies, and it is useful to think about it alongside efficiency.
How defensible profit margins are in a recession is down largely to the elasticity of demand for products and services (ie, how essential they are and whether there are competitors or viable substitutes) alongside companies’ pricing power and ability to pass on rising input costs to customers. Some companies, for example those that earn revenues from other businesses’ essential operating expenditure, are better placed than others. But efficiency is still important either way.
Total asset turnover tells investors how successful a company is at generating revenues from its assets. A low ratio can indicate inefficiency or that the business has a higher level of capital intensity. Investors may wish to avoid more capital-intensive businesses ahead of a recession if demand for products is elastic and revenues are more volatile. However, when it comes to building a watchlist for a potential market recovery, it is also worth noting that where high capital investment is required at the outset of a new business cycle, the asset turnover will be lower.
Further to this, the five-step Dupont analysis reinforces the fact that higher interest expense can hurt ROE if the credit cycle is working against indebted firms. It also looks at the impact of taxes.
Net income divided by earnings before tax (EBT) measures the proportion of a company’s pre-tax profits that it gets to keep. Meanwhile, the ratio of EBT to earnings before interest and tax (Ebit) shines a light on the effect of interest cost on ROE. The lower EBT is as a percentage of Ebit, the lower ROE will be.
When interest expense is acting as a drag on profitability, it works counter to the positive effect that leverage has on ROE. If a firm has floating-rate loans or is having to issue new bonds for long-term financing, then the cost of debt is rising if rates are heading higher. This is a reminder to look carefully at capital structure.
In summary, conducting this sort of analysis should lead investors to focus on resilient margins, operational efficiency and low or manageable leverage. It should also lend itself to picking companies with lower interest expense and capital expenditure requirements: in other words, firms that generate higher levels of free cash flow.
When it comes to deciding on entry points to buy shares, companies that look historically cheap on a price/free cash flow per share (P/FCF) basis aren’t guaranteed winners. Nonetheless, this metric is one to be aware of, in anticipation of the time when market sentiment improves decisively. Doing the homework now ought to be well rewarded.
| Dupont analysis on four quality shares | ||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Halma (HLMA) | Spirax-Sarco (SPX) | Experian (EXPN) | Diageo (DGE) | |||||||||
| Sep '22 | Mar '22 | Sep '21 | Jun '22 | Dec '21 | Jun '21 | Sep '22 | Mar '22 | Sep '21 | Jun '22 | Dec '21 | Jun '21 | |
| revenue | 1663.60 | 1525.30 | 1437.00 | 1450.90 | 1344.50 | 1267.40 | 5076.91 | 4605.67 | 4344.69 | 15452 | 13816 | 12733 |
| EBIT | 293.00 | 284.80 | 276.30 | 335.60 | 320.90 | 291.80 | 1193.32 | 1067.03 | 965.97 | 4798 | 4231 | 3744 |
| earnings before tax (EBT) | 282.40 | 304.50 | 167.60 | 303.00 | 314.50 | 283.90 | 425.36 | 609.18 | 472.64 | 3970 | 3860 | 3372 |
| net income | 223.60 | 244.40 | 261.90 | 222.90 | 234.60 | 205.70 | 737.21 | 843.04 | 706.59 | 3249 | 3045 | 2660 |
| avge total assets | 2377.25 | 2037.45 | 1947.70 | 1904.40 | 1804.15 | 1819.90 | 8520.51 | 7786.72 | 7383.95 | 34234.5 | 32982 | 32630.5 |
| avge total shareholders' equity | 1451.70 | 1284.85 | 1200.15 | 1004.40 | 932.00 | 879.10 | 2818.90 | 2623.78 | 2195.09 | 7347.5 | 7238 | 6834.5 |
| net income/EBT | 0.79 | 0.80 | 1.56 | 0.74 | 0.75 | 0.72 | 1.73 | 1.38 | 1.49 | 0.82 | 0.79 | 0.79 |
| EBT/EBIT | 0.96 | 1.07 | 0.61 | 0.90 | 0.98 | 0.97 | 0.36 | 0.57 | 0.49 | 0.83 | 0.91 | 0.90 |
| EBIT/revenue | 0.18 | 0.19 | 0.19 | 0.23 | 0.24 | 0.23 | 0.24 | 0.23 | 0.22 | 0.31 | 0.31 | 0.29 |
| revenue/average total assets | 0.70 | 0.75 | 0.74 | 0.76 | 0.75 | 0.70 | 0.60 | 0.59 | 0.59 | 0.45 | 0.42 | 0.39 |
| avge total assets/avge total equity | 1.64 | 1.59 | 1.62 | 1.90 | 1.94 | 2.07 | 3.02 | 2.97 | 3.36 | 4.66 | 4.56 | 4.77 |
| Return on equity | 15.40% | 19.02% | 21.82% | 22.19% | 25.17% | 23.40% | 26.15% | 32.13% | 32.19% | 44.22% | 42.07% | 38.92% |
| Source: FactSet and Investors' Chronicle | ||||||||||||
