Trend Analysis of ROE

Trend Analysis of ROE

       

It’s important to look at the profitability of a company in terms of what the shareholders have invested. That’s what Return on Equity does. It’s really made up of three other ratios.

Net Margin (net income / revenues) multiplied by asset turnover (revenue / assets) multiplied by leverage (assets / equity)

If you’re a math guy you notice that both revenues and assets cancel each other out (I’ve got grade eleven math myself but don’t tell anyone)

This is the DuPont model of ROE. It shows you where a company’s profits are coming from. It could be from margins, or is the company more efficient at turning over its assets? Or has the company taken on debt? In other words ROE measures not only profitability but efficiency of management as well as leverage. If the company has shown consistently high rates of ROE (over 13 percent) over the years, it should translate into strong earnings per share and a rising stock price. Keep in mind that banks and financial companies due to their financial structure will have overly high leverage ratios thus inflating their ROE’s so you should insist on a higher ROE from them than non-banking firms.

To really gain insight into a company’s performance you should track ROE over a period of a few years. There is no other way of telling whether a company’s performance is improving, remaining the same or, or deteriorating. Trend analysis will highlight the trends over time so the investor can make more informed investment decisions. Any company that can maintain a high ROE over time must be redeploying their cash productively or else the ROE would drop. In other words the management of these companies are good capital allocaters. Remember its not enough for management to be good operators of their business, they must be able to take their excess profits and put them back into the company to grow their business. High margins are a good sign, if they are slowly rising over time, even better. Keep an eye on the leverage ratio. If it is too high management may be trying goose returns by overly relying on use of debt. Higher turnover ratios mean the company is using its assets more efficiently.

By tracking these figures over the span of a few years the investor will be quickly able to separate the wheat from the chaff. And of course once you gain more experience working with these metrics, your intuitive side (right brain) will start playing a bigger role in the evaluation process...have fun.