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 or net margin, 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 M1 Ltd to the test
Let’s run telecommunications outfit M1 Ltd (SGX: B2F) through this exercise today. In the chart below, you can see how the three components of M1’s ROE have changed over the past five years:
We can see that M1’s ROE has undergone a gradual decrease, moving from above 56% in 2010 to around 44.5% in 2014.
When we dig into the components of the ROE, the gradual dip in the metric can be attributed to the marked decrease in M1’s financial leverage from around 3.1 in 2010 to 2.6 in 2014 (see the green line in the graph).
This may not be surprising if we study M1’s balance sheet over the past few years. The chart below shows how the telco’s borrowings have declined while its cash position has increased:
Source: M1’s earnings report
M1’s return on sales (red line in the first chart) has remained relatively consistent around the 15.5% mark over the five year period examined. For the asset turnover (denoted by the orange line), M1 has been able to churn out an average of about $1.01 in revenue for each asset dollar employed over the past five years.
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 M1’s case, it’s commendable that the firm has managed to keep its ROE at a very high level for the past five years despite a slight dip in the metric. That said, a firm’s ROE is just one element in the overall financial picture. M1 will still have to find new growth avenues over the long term in order to extract the most future value for its shareholders.
With that, the onus remains with the Foolish investor to decide if M1’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.