We had previously taken a look at some of Singapore’s most efficient blue chips by assessing their Return on Equity, or ROE. It measures the efficiency of a business in converting each dollar of shareholder capital into profits.
Naturally, we would want to see a high ROE in the companies we invest in as that means that our money’s being ploughed back into the business to earn better returns than we could achieve elsewhere.
But, the ROE measure alone can’t tell us the source of the company’s efficiency in generating profits. Is the source coming from a high profit margin, where each dollar of earnings makes up a high percentage of sales? Or, does the company’s high ROE stem from a better grasp at utilising assets to generate revenue? Or perhaps, a high return on shareholder’s dollars stems from the use of financial leverage?
These questions can be answered by using an analysis-tool known as the DuPont Analysis (in case you’re wondering, it was pioneered by the American chemical company DuPont, maker of the eponymous DuPont Paints among many other products). It breaks down a company’s Return on Equity into three categories:
- Profitability – defined as a company’s Net Income as a percentage of Revenue.
- Operating Efficiency – measured by dividing Revenue over the Total Assets of the company.
- Financial Leverage – calculated by the company’s Shareholders’ Equity as a percentage of Total Assets.
If we express ROE using the DuPont Analysis in a simple formula, it becomes:
ROE = (Net Income / Revenue) x (Revenue / Total Assets) x (Total Assets / Shareholders Equity)
Those Returns, From Whence They Came?
When comparing ROE figures of companies from the same industry, the DuPont Analysis becomes very useful in determining the sources of any differences in the returns.
We previously identified telecommunications operator Starhub (SGX: CC3) as the company with the highest ROE among the blue-chips listed in Singapore at 293%. That’s really no mean feat, especially when second-placed Singapore Exchange (SGX: S68), operator of the Mainboard and Catalist stock exchanges in Singapore, only managed a ROE of 39%.
The main reason for Starhub’s astounding ROE was due to its high leverage, expressed by its Gearing ratio of 500%. But, is there all there is to it? And, how does Starhub stack up against fellow telco operators, SingTel (SGX: Z74) and M1 (SGX: B2F), with ROEs of 14.8% and 38.4% respectively? Let’s use the DuPont Analysis to find out.
From the graphs below, we can see that Starhub’s superior ROE is the result of having the highest Financial Leverage as well as Operating Efficiency. Without the DuPont Analysis, high leverage might have been superficially pegged as the sole source of Starhub’s ROE.
Similarly, SingTel has the biggest asset base out of the three, and it might seem to be a formidable barrier for its competitors to overcome. But, it fares poorly in terms of making use of its assets to bring in sales, such that both M1 and Starhub can use that to their advantage to generate higher returns on shareholders’ dollars.
Foolish Bottom Line
Besides painting a finer picture on the sources of a company’s superior or inferior ROE, the DuPont Analysis can be used to track any changes in its components.
To offer just one simple of how this can be done, let’s imagine a company with a stable but high ROE. It looks great on first glance but, it can be achieved even in the face of falling profitability if a company keeps pumping debt into its balance sheet. That’s a potentially dangerous situation to be in for any business and the DuPont Analysis can point out changes in Profitability as well Financial Leverage to clue shareholders to the developing problem.
To find out more about different ways to analyse and understand the different numbers from companies’ financial statements, click here now for your FREE subscription to Take Stock Singapore, The Motley Fool’s free investing newsletter. Written by David Kuo, Take Stock Singapore tells you exactly what’s happening in today’s markets, and shows how you can GROW your wealth in the years ahead.
The Motley Fool’s purpose is to help the world invest, better. Like us on Facebook to keep up-to-date with our latest news and articles.
The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.