A Quick but Insightful Approach to Finding Winning Investments – Part 1

At the Fool, we favor businesses with superior operations that can deliver long term returns for investors.

To figure out how well a business is run, we can look to a company’s return on equity (ROE). The ROE is a measure of how well a company generates profits for every shareholder dollar used in the business.

While the ROE is a good measure in itself, we can go a step further to gain further insights. Breaking the ROE down into three other ratios may help us see how well a company is actually being run.

Breaking up the ROE

In particular, we are looking to break the ROE into the following ratios: return on sales; return on assets (or asset turnover); and financial leverage. The breakdown is seen below:

ROE return on equity

For a succinct description of the individual elements, I’d turn to author and analyst Dennis Jean-Jacques’s book, 5 Keys to Value Investing:

“Return on sales (ROS) indicates the amount of profits a company is able to keep for each dollar that the company takes in from the sale of goods and services. Asset turnover show the amount of revenues the company is able to generate for each dollar of assets committed. Financial leverage shows investors how many dollars of assets the firm can use for every dollar of equity.”

Let’s move on with a few examples of Singapore-listed companies. To study further, I will use two companies in the restaurant industry: Soup Restaurant Group Ltd (SGX: 5KI) and Japan Foods Holding Ltd (SGX: 5OI).

In the table below, I have summarized the three components of the ROE metric for the two companies:

ROE table for Soup Restaurant and Japan Foods

Source: Morningstar; based on trailing-12-month figures

From the table above, we can see that the return on sales (or net margin) for Japan Foods is superior to that of Soup Restaurant. This means that Japan Foods keeps more profits for each dollar of sales. At a net margin of 8.5%, Japan Foods churns out a profit of $8.5 for each $100 of sales.

That said, Soup Restaurant edges out Japan Foods when it comes to asset turnover – in other words, Soup Restaurant has been making more sales per asset dollar employed. With an asset turnover of 2.35, Soup Restaurant is generating $235 in sales for every $100 employed.

With financial leverage for both restaurant operators fairly close to each other, it’s the higher net margins that made the difference for Japan Foods – its ROE of 19.1% towers over Soup Restaurant’s ROE of 8.6%.

Still with me so far? Great! Click here to follow along as I dig deeper into the important ROE metric.

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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.