The Importance Of Return On Equity Decomposition

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Includes: AAPL, AMP, CAT, CMI, DWDP, HP, IBM, WBA
by: Abba's Aces

Summary

Not all returns on equity are created equal.

Companies in the same industry with the same ROE can have the same ROE for different reasons.

I've added an additional filter in my screens to screen out companies with much higher debt than equity.

Most investors take a look at return on equity as a measure of how well a company is doing with respect to net income as a ratio to shareholders equity on the balance sheet. Companies such as IBM (NYSE:IBM), Boeing (NYSE:BA), or Altria (NYSE:MO) even have huge returns on equity. Typically a high return on equity value is pretty nice to have, but not all returns on equity are equal.

Although it is a straight ratio as suggested, it is a bit more complex than that. Not many investors know this, but return on equity can actually be decomposed into three parts, made popular by DuPont (DD) back in the 1920s. The decomposition of return on equity tells us three things:

  1. Operating efficiency, which is measured by profit margin
  2. Asset use efficiency, which is measured by total asset turnover
  3. Financial leverage, which is measured by the equity multiplier

Prepare yourself for some algebra; I promise it will be pretty easy. We already know that profit margins are dictated by the equation of profit/sales. Total asset turnover is dictated by the equation of sales/assets and the equity multiplier is dictated by the equation of assets/equity. So when we put multiply them all together we get the following proof:

Profit

*

Sales

*

Assets

=

Profit

=

ROE

Sales

Assets

Equity

Equity

I for one used to be one of those people that just used to search for really high returns on equity on my stock screens along with a couple of other filters. But when I learned about the decomposition of the famous financial metric I decided that I needed to add one more filter to my screens.

The part that of the proof above that got me to add the additional filter to my screens is the equity multiplier portion. Depending on how a company chooses to finance its assets (by debt or by equity), the equity multiplier can be really huge, causing the overall return on equity to be high. Personally I don't like a whole lot of debt on the balance sheet and that is why I've added a filter of debt to equity ratio of less than 0.5.

I know a debt to equity ratio of 0.5 is a bit extreme, but when you do the screen you get great companies like Apple (NASDAQ:AAPL), Johnson & Johnson (NYSE:JNJ), etc. I don't believe that a strategy of carrying a lot of debt on the balance sheet is very sustainable. Let's take a look at some well known companies and their return on equity decompositions to put our newfound knowledge to work.

Company

Ticker

Profit Margin

Asset Turnover

Leverage

ROE

Apple

AAPL

21.61%

0.83

1.84

32.76%

IBM

IBM

15.70%

0.79

6.93

85.71%

Cummins

(NYSE:CMI)

8.76%

1.24

2.00

21.56%

Caterpillar

(NYSE:CAT)

7.12%

0.65

4.23

19.51%

Helmrich & Payne

(NYSE:HP)

24.20%

0.56

1.40

18.81%

Ameriprise

(NYSE:AMP)

12.27%

0.08

17.67

17.94%

Walgreen

(WAG)

2.53%

2.06

1.79

9.35%

So of all the companies on this list, Ameriprise is kind of an outlier as it is a financial company. Almost all companies in the financial sector carry a high amount of debt because it is the nature of their business. But if we take a look at Cummins versus Caterpillar we see that CAT's ROE is propped up by a pretty large leverage ratio. These are two companies which operate in the industrial sector so they are pretty good comparisons to each other. From the breakdown I'd much rather choose Cummins as an investment than CAT. As you can see, the only thing propping up IBM's exorbitant ROE is the extremely high leverage ratio. After showing a couple of examples I hope you'll see ROE in a different light, I know I for sure do.

Disclaimer: This article is in no way a recommendation to buy or sell any stock mentioned. This article is meant to serve as a journal for myself as to the rationale of why I bought/sold this stock when I look back on it in the future. These are only my personal opinions and you should do your own homework. Only you are responsible for what you trade and happy investing!

Disclosure: The author is long AAPL, AMP, DD, HP, WAG, CAT, CMI.

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.