At the Motley Fool, we favor businesses with superior operations as they are the ones that can deliver long term returns for investors. To figure out how well a business is run, we can look into a company’s return on equity (ROE). The ROE is a measure of how much profit a company generates 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 even more insights. Breaking the ROE down into three other ratios may help us see how well a company is actually being…
At the Motley Fool, we favor businesses with superior operations as they are the ones that can deliver long term returns for investors.
To figure out how well a business is run, we can look into a company’s return on equity (ROE). The ROE is a measure of how much profit a company generates 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 even more 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 down the ROE into three metrics, namely the return on sales, return on assets, and financial leverage.
With reference to the equation above, the first ratio (net income divided by sales) can be referred to as the return on sales, the second ratio (sales divided by assets) is the return on assets or asset turnover, and the third (assets divided by equity) is financial leverage.
For a succinct description of the individual elements, I turn to a passage from 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.”
Putting Super Group to the test
Let’s run instant coffee maker Super Group Ltd (SGX: S10) through this exercise today.
In the chart below, you can see how the three components of Super Group’s ROE have changed over the past five years:
For Super Group, its ROE has undergone a notable decline over the past year. But to the company’s credit, it has still been able to keep its ROE above a healthy level of 14%.
When we dig into the components of Super Group’s ROE, we can observe that the strength of its ratio comes from its respectable return on sales (or net margin) of around 13%. Beyond that, we can also see that a modest amount of financial leverage has also been used over the past five-plus years and that may be a sign that the company’s not trying to take on undue levels of financial risk.
Meanwhile, the instant coffee company has also been able to eke out an average sales of about 93 cents for each asset dollar employed over the past five years.
Regarding the decline in ROE in 2014, we can see that the main culprit is a shrinking net margin. The asset turnover also has a role to play (albeit a smaller one) with the figure slipping from 98 cents per asset dollar in 2013 to 88 cents per asset dollar in 2014. A lower asset turnover means that Super Group has generated less revenue for each dollar of assets deployed over the past year.
Both components, namely the asset turnover and return on sales, are certainly worth keeping an eye on for the future.
A Fool’s take
A winning stock may be found when a company demonstrates a consistent track record of generating superior value for each shareholder dollar it has at its disposal.
In this case, Super Group may turn into a winning stock if it is able to maintain its ROE over the long term. But beyond that, the Foolish investor may also want to look at the possibility of future growth in the company’s business that may allow it to generate even more value.
With that, the onus remains with the Foolish investor to decide if Super Group’s current share price provides an appropriate margin of safety and whether it fits into his or her portfolio.
For more stock analyses and investing tips, sign up here for your FREE subscription to The Motley Fool's weekly investing newsletter, Take Stock Singapore. It will teach you how you can grow your wealth in the years ahead.
Like us on Facebook to follow our latest hot articles.
The Motley Fool's purpose is to help the world invest, better.
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 owns shares in Super Group.