Return on equity can be an important metric to consider when evaluating companies for investment. In fact, the most successful investor of all time, Warren Buffett, considers it one of the most important factors to evaluate.
The simple calculation is net income divided by average shareholder equity. But return on equity tells a much deeper story if you look closer. It is made up of several components, each of which can provide valuable insight into a company, its operations, capital structure, and profitability. While the simple formula for ROE is fairly straightforward, it can be further broken down using what is called the DuPont formula. The name comes from DuPont Corporation that started using the metric sometime before the Great Depression.
The DuPont formula breaks down the return on equity metric into three parts, each of which tells a story about the company and how they are able to generate returns for shareholders.
The ROE breakdown using the Dupont formula is:
Net Margin - profit margin measures the level of profitability of a company, particularly when comparing it to other companies within the same industry. One company may have higher profit margins than a competitor due to lower cost of production, premium pricing, economies of scale, a leaner business model, higher efficiencies, or any number of other reasons.
Financial leverage - this ratio measure the amount of debt used to finance the purchase of assets that enable a company to produce goods or services and generate sales. Whether a company uses debt or equity to raise capital will depend on the cost of capital of both of those sources, and others. Typically, the cost of debt tends to be lower than the cost of equity, and in a low interest rate environment, companies are inclined to issue debt and increase leverage.
When debt is used to raise capital, and that capital is used to invest in profitable activities, the return on equity will tend to rise.
Asset Turnover - asset turnover measures a company's use of assets to generate sales. For example, companies with a high level of assets may require a proportionately higher level of sales in order to achieve the same asset turnover as a company with fewer assets. Some businesses are operated to minimize assets, such as semiconductor companies that outsource production of the chips while keeping the research and design function in-house
By analyzing each of these components separately, investors can gain valuable insight into the future trends of a particular company.
Apple (NASDAQ:AAPL) has a very high return on equity. For the latest quarter ending March 2014, Apple had a return on equity of 32%. This is a very high level of ROE and would certainly meet Warren Buffett's 15% requirement. And it is also better than other mega-cap technology companies such as Cisco (NASDAQ:CSCO), Microsoft (NASDAQ:MSFT), Oracle (NYSE:ORCL), and Google (NASDAQ:GOOGL), with return on equity of 14%, 27%, 24%, and 16%, respectively. But looking at the details of ROE calls for a cautious evaluation of the current and future trend of the mammoth iEverything company.
As the chart below indicates, net margins have been on a downward trend since Q3 2011. This is no secret, as analysts and journalists have both been skeptical about Apple's ability to maintain high margins, particularly if it moves aggressively into emerging markets, where income levels are much lower than in the developed world.
Since reaching a net margin of 29.7% in Q1 2012, Apple's margins have only exceeded 25% once and the trend is evidently downward.
Meanwhile, the company issued its first bond during the second quarter of 2013, and while leverage is only slightly higher than in the quarters leading up to the first bond issuance, it is still reasonable.
In fact, until April of 2013, Apple had absolutely no debt on its balance sheet so total liabilities consisted primarily of current liabilities (accounts payable, taxes payable) and other long-term liabilities.
What's most interesting about breaking down Apple's ROE is the relationship between asset turnover and the launching of new products. The chart below shows the volatility of asset turnover on a quarter-to-quarter basis, with noticeable spikes in Q4 2011, Q4 2012, and Q4 2013. Each of those spikes were the result of an increase in sales during that period, which coincided with the launch of the iPhone 4S, iPad Mini, and iPhone 5 (launched in late September), in each respective quarter.
And despite success launching each of those products mentioned, asset turnover has been on a downward trend since 2011.
This has caused return on equity for Apple to also decline from a recent high of 63% during Q4 2011 to 32% in Q4 2013, an almost 50% drop in ROE.
Interestingly, if we analyze the three components of ROE to determine which one, if any, has the biggest impact on ROE, we find that ROE is almost directly correlated to asset turnover. The chart below shows both ROE and asset turnover and it is evident that the metrics are closely aligned.
Intuitively, this makes sense, since sales tend to spike in those quarters when new products are launched. But then Apple is faced with the specific challenge that many Apple critics have voiced, which is that the business model is too dependent on the successful periodic and frequent launch of new versions of products.
How long can Apple continue to awe with innovative new products? At what point do regular consumers diminish the added value of newer versions of existing products?
Returning to the issue with ROE trends, what's most troubling about the decline in ROE is that it has occurred despite increases in financial leverage, which is supposed to help drive ROE higher. The chart above shows the slightly upward trend in financial leverage over the period being evaluated. Leverage was within the 1.45 to 1.53 range until June 2013, when the company issued its first debt. Since then, the financial leverage ratio has been in the range of 1.62 to 1.73. It hasn't been a huge increase and debt/equity levels are still relatively low, but if financial leverage isn't helping to drive ROE, then the company must find other levers to focus on.
I am not suggesting that Apple should be sold out of portfolios. After all, it still does have a 30%+ return on equity, and ROE isn't necessarily the only driver of potential shareholder returns. But to reverse declining ROE, Apple has several options:
- Increase margins - While Apple certainly has pricing power in the U.S., there is plenty of research out there that outline the challenges Apple faces growing market share in emerging markets, particularly in markets where income levels are depressed and the volume of $500+ phones will remain at low levels. There is also competition from Samsung (OTC:SSNGY) and others using Android phones or phones with other operating systems that are more cost friendly. Despite Apple's popularity and the aspirations of many emerging market consumers to own Apple, this option may pose a challenge.
- Return cash to shareholders through dividends or share buybacks? - Apple has tons of cash on the balance sheet and it has already returned cash to shareholders via buybacks and dividends. But if management wants ROE to return to previous levels or at least prevent any further declines, Apple may have to increase its dividend yet again, or consider additional share repurchases. It already authorized an additional $130 billion share repurchase plan. (all else equal, paying out dividends reduces equity, which should increase ROE)
- Continue to increase leverage - With interest rates still at near-historic lows, Apple can issue additional debt and further increase leverage. Since last year, it has issued over $17 billion in debt with coupon payments as low as 0.45% and no higher than 4.45% for bonds that don't mature until 2044. With a debt-to-equity ratio of just 0.14 and interest coverage of over 100x, issuing additional debt will not over lever the company.
The best approach is probably a combination of two or more of the above mentioned options. The latter two seem to me to be the most viable and as previously mentioned, the company has already approved a share buyback program.
As of the date of this article, there has not been any mention of additional debt being issued, but it wouldn't surprise me if it issued another round of debt financing in anticipation of rate increases later this year or next.
The bottom line is that while Apple is still a great company, it does face some challenges maintaining the same return on equity it has enjoyed over the last several years. It can be done, but it is certainly something to watch out for.
Disclosure: The author is long CSCO, ORCL, GOOGL. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.