Return on equity (ROE) is one of the most important indicators of a firm's profitability. ROE shows how well a company uses investment funds to generate earnings growth and is an indicator of potential dividend growth. By completing a ROE analysis using the Dupont formula, an investor can understand the key drivers of that return: profitability, operating efficiency, and financial leverage.
The importance of the Dupont analysis becomes clear when examining the soft drink industry. Three companies combined hold almost 90% of the entire market share of the carbonated soft drink in the U.S. - Coca-Cola (KO), PepsiCo (PEP) and Dr. Pepper Snapple (DPS). All three have an ROE of approximately 27-28%, suggesting that they are evenly matched in terms of profitability and potential growth. However, a closer examination using the Dupont equation shows some important differences.
Below is the Dupont model breakdown for each company using data from the latest 10-K reports available:
|Net Profit Margin||18.9%||9.5%||10.5%|
While all three have roughly equal return on equity, Coca-Cola earns this return primarily through its margins, while Pepsi and Dr. Pepper both have significantly higher equity multipliers. This means the companies are earning their return from using higher levels of leverage. For example, if Dr. Pepper removed all leverage, its return on equity would drop to 7%. Leverage is accounting for almost 75% of the return on equity DPS is achieving.
By applying this same model to the historical returns over the past 5 years, we can get a better sense of the ROE trend for each company and what the key drivers are.
Historical Return on Equity & Equity Multiplier
A review of the 5-year ROE trend for Coca-Cola shows that, except for a brief increase in 2010, the company has consistently been earning a high-20% return on its equity. PepsiCo's ROE sharply declined in the first half of this period before also settling around high-20s to 30%. In contrast, Dr. Pepper's almost doubled over the 4-year period (2008 was excluded due to negative earnings), and has been in the high-20% range for the past two years.
Clearly PepsiCo's ROE has declined (41% to 28%) and Dr. Pepper's has risen (17% to 28%) significantly. By assessing the equity multiplier over this same time period, we can better gauge the driver of these changes (or stability in the case of Coca-Cola).
This graph reveals several interesting points. First, leverage has become increasingly important for generating return on equity in all three companies over the past 4-5 years. Second, Coca-cola has consistently had the lowest equity multiplier in each of the past five years, which is consistent with our more recent observations. Finally, it is interesting to note that Pepsi has experienced declining return on equity, while relying more heavily on leverage to generate its return on equity.
Overall, the ROE and Dupont analyses show that Coca-Cola generates more of its return on equity from internally-generated sales and profit margins, as oppose to leverage. Yet the market does not seem to be pricing in the higher level of risk associated with Pepsi's ROE.
|P/E Ratio||P/BV Ratio||EV/EBITDA|
KO and PEP have an equivalent price to earning ratio and price to book value, although DPS is discounted relative to both. Based on the results from the DuPont analysis, it understandable why DPS would be priced at a lower multiple. It's lower credit rating also reinforces the idea that investors should carefully consider its use of leverage.
However, based strictly on this analysis, I would expect KO to receive a premium to PEP as well. Interestingly, this is the case with the enterprise value to ebitda ratio, which takes the company's' capital structure into account more than a straight price to equity ratio.
Obviously, there are many factors that go into stock valuations and return on equity is only one thing for investors to consider. However, the DuPont analysis may help investors to identify companies that have a stronger brand, or that can generate revenue with less risk.