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 managed.
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 SembCorp Marine to the test
Let’s run rig builder SembCorp Marine Ltd (SGX: S51) through this exercise today.
In the chart below, you can see how the three components of SembCorp Marine’s ROE have changed over the past five years:
Similar to fellow rib builder Keppel Corporation Limited (SGX: BN4), SembCorp Marine’s ROE has undergone an obvious decline over the past few years, moving from above 30% in 2010 to a little under 20% in 2014. But despite the shrinking ROE, Sembcorp Marine’s feat in keeping the figure above a healthy level of 19% would still deserve a thumbs up.
When we dig into the components of Sembcorp Marine’s ROE, we may attribute the fall in the important metric to the company’s decline in return on sales (see the red line in the graph). Worryingly, Sembcorp Marine’s return on sales – also known as net margin – in 2014 came in below 10%, a significant change from where it was in 2010. This trend is certainly worth keeping an eye on for the future.
Meanwhile, SembCorp Marine has been able to churn out an average revenue of about 82 cents for each asset dollar employed over the past five years. This tops Keppel Corp’s average of 46 cents over the same period.
On the other hand, SembCorp Marine has also been employing more financial leverage over the past five years (you can get a feel for this in the green line above). The rise in financial leverage has helped SembCorp Marine to partially offset the decline in net margin to hold up its ROE.
This is another area for investors to watch as it may not be ideal for the company’s ROE to be propped up by increasing financial leverage alone – generally speaking, the higher the financial leverage used, the more risk a company’s taking on.
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, SembCorp Marine needs to keep its net margins up in order to excel in the cyclical oil and gas industry that it calls home. But beyond that, the Foolish investor may also want to look at the possibility of future growth that may allow the company to generate even more value.
With that, the onus remains with the Foolish investor to decide if SembCorp Marine’s current share price provides an appropriate margin of safety and whether it fits into his or her portfolio.
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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.