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 Singapore Technologies Engineering to the test
Let’s run engineering giant Singapore Technologies Engineering Ltd (SGX: S63) through this exercise today. Also known as ST Engineering, the conglomerate is a blue chip component of the Straits Times Index (SGX: ^STI) and has multiple engineering business interests spanning the aerospace, electronics, land systems, and marine sectors.
In the chart below, you can see how the three components of ST Engineering’s ROE have changed over the past five years:
First off, we can see that ST Engineering’s ROE has undergone a decline over the past five-plus years, moving from a level above 30% in 2010 to around 25% in 2014. What’s good to note though, is that the company has been able to keep its ROE at a very robust level of above 25%.
When we dig into the components of the ROE, we may attribute the change in the financial metric largely to the decline in financial leverage (the green line in the chart above).
When we compare this observation with ST Engineering’s balance sheet over the same period (see chart below), we can see why that’s so: ST Engineering’s debt has come down significantly, with the end-result being the company’s net cash position (cash and equivalents minus total debt) in 2014 almost doubling that in 2010.
While the use of lower financial leverage has pressured ST Engineering’s ROE, this may also be viewed as a positive sign since less debt would mean that the company has less financial risks to worry about.
Source: ST Engineering’s earnings report
For its asset turnover ratio, ST Engineering has been able to churn out an average of 81 cents of revenue for each asset dollar employed over the past five years; the ratio has also remained very steady during that period. Meanwhile, ST Engineering’s return on sales (or net margin) has also remained in a very tight band over the past five years. You can see all these in the red and orange lines in the first chart above.
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, ST Engineering may be demonstrating discipline in keeping its net margin and returns on asset stable while improving its balance sheet. But that said, maintaining a solid ROE may not be enough – the engineering conglomerate will still need to find ways to expand its revenue in order to take advantage of its high ROE. This – growth in revenue – may be one area where the Foolish investor should keep his or her focus on when it comes to ST Engineering.
With that, the onus remains with the Foolish investor to decide if ST Engineering’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.