1 Quick Way For You To Better Understand Outperforming Shares

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The Return on Equity (ROE) is often a favourite ratio among investors. At its core, the ratio measures the amount of profit produced (measured by net income) as a percentage of the money investors put in (shareholder’s equity). A typical use of the ratio is as a yardstick to measure the financial performance of a company.

However, there is more we can do with the ratio – and that is, to understand a little more on the business itself.

By breaking up the equation for ROE into three separate pieces – a technique known as the Dupont Analysis – we can begin to look deeper into different companies. The three separate pieces can be identified as the net margin, asset turnover, and the asset leverage respectively. This is shown in a form of an equation below:

Return on Equity = (Net Income / Sales) x (Sales / Assets) x (Assets / Shareholder’s Equity)

To go further, let’s look at three SGX-listed companies which have ROEs which out-perform the Straits Times Index’s (SGX: ^STI) own average ROE:

Company Return on Equity Net Margin % Asset Turnover Asset Leverage
Dairy Farm International Holdings Ltd (SGX:D01) 37.3% 4.95% 2.61 2.88
Sarine Technologies Ltd (SGX:U77) 35.8% 31.6% 0.93 1.22
Osim International Ltd. (SGX:5UJ) 29.7% 15.8% 0.95 1.98

Source: Morningstar (based on the financial year ended 2013)

Although the ROEs for the trio are at or above 30% – which might mean all three are of similar ‘quality’ – the separate components which make up the ratio show how different each business is.

For instance, Sarin Technologies Ltd – a diamon-polishing systems maker – comes up tops in terms of net margin. This means that it makes the most profit for each dollar of sales made. But before we let it take a victory lap, we have to point out that pan-Asian retailer Dairy Farm International Holdings Ltd has the highest asset turnover of the three. This is to say that that Dairy Farm has been able to generate the most sales for each dollar of asset it uses.

We should not be too surprised by this finding when we contrast the business of Sarine and Dairy Farm. Dairy Farm is in the business of making millions of small sales each day for everyday groceries, consumer care products, furniture, and the likes – in other words, it collects smaller pieces of profit per sale, but does so many times during the day. Sarine, on the other hand, is in the business of making less frequent sales of diamond polishing systems, but with higher margins each time. Osim International Ltd., in this case, sits somewhere in between the duo with a net income margin of 15.8% and an asset turnover comparable to Sarine.

It should also be noted that Osim’s asset leverage stands at 60% more than Sarine, which is to say that it employs more leverage to achieve its returns. Dairy Farm, though, is the most aggressive in its use of leverage.

The reason for this, is that Dairy Farm’s business (groceries) can be considered comparatively stable relative to more discretionary purchases such as massage chairs (from Osim) or diamond polishing systems (from Sarine). Said differently, while the business environment of Dairy Farm offers lower margins, it also offers a higher degree of market certainty for it to employ more leverage and thus allow the company to still bring in a high ROE.

Foolish Take-Away

The observation of the dynamics within the ROE ratio should not be a “be-all and end-all”. It simply offers a quick and simple way for you to understand the business.

And, there is more to study. A quick historical look reveals that Sarine’s sales tumbled in 2008. When that happened, the net income margin was crimped together with the fall. Naturally, the ROE followed suit, quickly tumbling down to mid-single digits for the year.

So, from this historical view, we can take away that it is perhaps even more important to observe for consistency of the ROE ratio of a company over the long term. There can be a good reason for this: It is because when we discover the consistency in performance over years or even decades, it might just be the trait that leads us to the investing returns which we are looking for.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.