You can see above an image of a Du Pont model I took from Google Images. This is one of the most important ways to assess a company’s performance and find out why changes have occurred with a business’ fundamentals. It is, in essence, an algebra problem. It begins with:
Return on Equity = Financial Leverage * Return on Assets
(Net Income/Equity) = (Assets)/(Equity) * (Net Income)/(Assets)
You’ll notice that the Assets in both equations on the right (Financial Leverage & Return on Assets) negate each other, seeing as one is in the numerator and one is in the denominator. When multiplied together, they are taken out and you are left with Net Income divided by Equity, or Return on Equity (ROE). Most investors focus on this metric, ROE, but few people focus on where it comes from. You can get a large ROE figure from either employing a large amount of debt or from getting a large Return on Assets (ROA). So let me pose the question, which would you rather have, a company with a large amount of debt, or one with highly efficient assets? I know what Warren Buffett looks for; take a look at number 3:
I took this clipping directly from the 2009 Annual Report. Although Buffett does not come out and say it directly, he is searching for companies with high return on assets. After having given this much thought, it makes perfect sense. The measure that truly matters in assessing the track record of management’s investment in assets, as well as the efficiency of those assets, is very important when analyzing a company. A high ROA figure can show many things, let me walk you through it.
Take a look back at the Du Pont model on the first page. Financial leverage cannot be broken down; it is pretty simple to understand. It is just the debt that a company takes on. However, Return on Assets can be broken up further into Asset Turnover and Net Profit Margin. Here is the math:
Return on Assets = Asset Turnover * Net Profit Margin
(Net Income)/(Assets) = (Sales)/(Assets) * (Net Income)/(Sales)
You will notice that the sales drop off from the right side of the equation (Numerator on Asset Turnover, Denominator on Net Margin). Considering I have broken ROA into two pieces, what does each piece tell us?
Asset Turnover can be best thought of as “the amount of sales generated per dollar of assets”. This is another measure of efficiency. I know I said ROA is best thought of as the efficiency of assets, but the Asset Turnover also shows us this further. The more dollars of sales generated from each dollar of assets will show us that the business does not require an large amount of assets in relation to the amount of goods sold. The more sales generated in relation to a company’s assets, the better the situation for you as an investor. You don’t want a business that requires a large amount of assets to operate, because it will require much more investment in those assets if they want to maintain those assets or grow further. For example, what types of automobiles do you generally see pizza delivery businesses using? For the companies that own the cars that the deliverymen use, you’d be shocked for someone to pull up in a Porsche. This would simply cost far too much to complete the simple task of delivering food to your door. You will see very small cars or cheap, used cars to deliver the pizza. This inherently, is common sense, but when comparing companies across industries, it is important to you to see the efficiency of those assets. The Porsche, let’s say, cost $100,000 each. A used car cost the company $5,000. With the same amount of sales, at say, $50,000 would show you Asset Turnover at:
Porsche: $0.50 sales per dollar of assets
Used Car: $10.00 sales per dollar of assets
I’d rather have the company that generates more money per dollar of assets. This is true of companies that either have assets that cost more money, or just more total assets in general.
The other part of Return on Assets is the Net Margin. The idea is, instead of having a large number of sales dollars generated from the assets, you could have a large amount of your sales dollars become profit. With a company having lower expenses and higher overall margins, they can sport a higher ROA. Think of it this way, “It’s all about quality, not quantity.” Although a company can churn out a large amount of sales in relation to assets, if the quality of those sales dollars isn’t very high, they are only getting a small amount of profit from every dollar. One thing to keep in mind with the Net Margin: it is easily hurt by inflation. With higher costs of operating a business, if the company cannot pass those costs onto the consumer, the ROA will suffer. Margins are pretty self-explanatory on the Income Statement, so for a better discussion of them, just check out the Internet.
You will notice that the Du Pont model is broken up even further from here, but my discussion ends now. I do not break up a company’s financials any further because after this point, you would only break it up if you were interested in any bizarre changes in the company. You can take it further in your own investment strategy, but I have not seen a great use for this.
One last thing to note, the Du Pont model is very important to write out for a company’s historical financials. You will want to be able to compare why the ROE changed over the last decade and the various causes of changes over the years. You can pinpoint what changed and see how a company’s fundamentals are affected in different economic conditions. I am a firm believer in consistency, so it is nice to see what happens when things change. For every investment I have, I run it through a 10-year Du Pont model to see how every aspect of the business changes.
Everyone is always talking about the Return on Equity and that it is very important for it to be high. I hope that this discussion will aid you in finding companies with high ROE and help you understand why the ROE is so high, compared to competitors.
Here is the pdf: DuPont Model