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 Industries to the test
Let’s run SembCorp Industries Limited (SGX: U96) through this exercise today. SembCorp Industries’ main business lies in the provision of utility services (think power plants and wastewater treatment facilities) and marine engineering works. The latter comes through Sembcorp Industries’ majority ownership of SembCorp Marine Ltd (SGX: S51)
In the chart below, you can see how the three components of SembCorp Industries’ ROE have changed over the past five years:
In a similar manner to its subsidiary SembCorp Marine, SembCorp Industries’ ROE has undergone a sustained and sizeable decline over the past five-plus years, moving from above 22% in 2010 to a little under 15% in 2014. That said, it’s worth noting that the company has been able to keep its ROE above a solid level of 15%.
When we dig into the components of Sembcorp Industries’ ROE, we may attribute the fall in the financial metric to declines in both the return on sales (the red line in the graph) and asset turnover (the orange line). These are trends that investors may want to observe for the future.
SembCorp Industries has been able to churn out an average of about 80 cents of revenue for each asset dollar employed over the past five years. This compares well with the average of 46 cents per asset dollar employed that fellow conglomerate Keppel Corporation Limited (SGX: BN4) has achieved over the same period. That said, SembCorp Industries’ asset turnover has declined from 0.87 in 2010 to 0.70 in 2014.
Meanwhile, SembCorp Industries has started ramping up the amount of financial leverage it’s using in its business in recent years (see the green line). The rise in SembCorp Industries’ financial leverage has helped to partially offset the declines in its return on sales (also known as net margin) and asset turnover and thus help prop up the ROE.
This is another area to watch as it may not be ideal for a company’s ROE to be maintained by the use of growing financial leverage alone; generally speaking, the higher the financial leverage, the more financial risks a company’s exposed to.
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 the case of SembCorp Industries, it needs to keep its net margins up in order to excel in the cyclical oil and gas industry and to weather hiccups in its utilities segment.
To the points about volatility and hiccups, you can see in the chart below that Sembcorp Industries has experienced a decline in revenue from its utilities segments over the past two years. Meanwhile, the Marine segment has been generating topsy-turvy revenue over the past five years.
Source: SembCorp Industries’ earnings report
Investors may want to look out for improvements in both business segments as well as dig into the possibility of SembCorp Industries maintaining or growing its ROE in a sustainable manner; if the firm can do these things, it can then likely generate more value for shareholders in the process.
With that, the onus remains with the Foolish investor to decide if SembCorp Industries’ 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.