Welcome to the next part of my deeper look into the important return on equity (ROE) metric. In my previous article, we looked at breaking the ROE into the following three ratios: return on sales (net income divided by sales); asset turnover (sales divided by assets); and financial leverage (assets divided by equity). The breakdown of the ROE elements can be seen below: I also illustrated the concept by using two restaurant companies – Soup Restaurant Group Ltd (SGX: 5KI) and Japan Foods Holding Ltd (SGX: 5OI) – as examples. Let’s move on from there. Another view…
Welcome to the next part of my deeper look into the important return on equity (ROE) metric.
In my previous article, we looked at breaking the ROE into the following three ratios: return on sales (net income divided by sales); asset turnover (sales divided by assets); and financial leverage (assets divided by equity).
The breakdown of the ROE elements can be seen below:
Another view of ROE
The ROE figure at any point in time is important. But it ultimately is just a snapshot of the operational metrics of a company at a certain point of time.
For even more useful insights, we can also look at the historical progress of the broken-out ROE to determine the key drivers of a company’s business performance.
I’d stick with Japan Foods Holding as an example. In the chart below, I have summarized the firm’s three broken-out ratios since FY2010 (financial year ended 31 March 2010).
Source: Morningstar; TTM = trailing twelve months
As you can see above, Japan Foods has experienced fluctuations in its ROE over the past four-plus years. That said, the company has been able to keep its ROE above a respectable level of 15% during that time frame.
The return on sales (or net margin) seems to be the major factor driving the changes in Japan Foods’ ROE.
One notable comparison would be between Japan Foods’ ROE for the trailing twelve months period and the ROE in FY2012. Although the ROEs for both periods are roughly similar, the trailing twelve months ROE was achieved on the back of higher return on sales and a lower asset turnover as compared to FY2012’s ROE.
Said another way, over the last 12 months, Japan Foods had made less revenue per asset dollar deployed, but managed to generate more profit from each dollar of revenue gained when compared with FY2012.
The breakdown of the ROE is one way to understand a company’s operations. What is desired may be a company with consistently high ROEs over many years.
Foolish investors will note that the ROE is not the only ratio to look for. The ROE tells you very little about the market opportunity a company has, or the valuation of its shares, for instance.
But if it is a head start you are looking for, breaking up the ROE into three other useful ratios may give you a helping hand in finding winning investments.
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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.