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 SMRT Corporation to the test
Let’s run transportation firm SMRT Corporation Ltd (SGX: S53) through this exercise today. In the chart below, you can see how the three components of SMRT’s ROE have changed over the past five years:
At first glance, we can see that SMRT’s ROE (represented by the blue bars) has halved over its past five fiscal years, moving from above 20% in the financial year ended 31 March 2011 (FY2011) to a little over 10% in FY2015.
Of the three main components of the ROE, we may attribute the fall in the important metric to the marked decrease in return on sales (see red line). In this case, the net margin has declined from 16.6% in FY2011 to around 7% in FY2015.
Worryingly, SMRT has also seen its financial leverage (green line) move up from around 2 in FY2011 to nearly 3 in FY2015. This may not be a surprising development when we look at the company’s balance sheet (see graph below). The transportation outfit’s borrowings have spiked up while its cash position has mostly decreased over the past five fiscal years.
Source: SMRT’s earnings report
On a brighter note, SMRT has been able to churn out a relatively stable asset turnover over the period under study; the land transport provider had clocked an average of about 58 cents of revenue for each asset dollar employed. In FY2015, SMRT reported ridership of 730.6 million for its Mass Rapid Transit (MRT) operations and a ridership of 383.3 million for its bus operations; the large number of rides helps keep the firm’s revenue levels up.
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 SMRT’s case, it has struggled to keep its ROE at an acceptable level in its past three fiscal years. The company’s increasing debt is also a concern. Moving forward, all eyes should also be on how SMRT’s bus operations will be affected (for better or for worse) as a result of the new government bus contracting model that will kick off in 2016.
But for the moment, SMRT could prove to be “too hard” for the Foolish investor.
That being said, the onus still remains with the Foolish investor in deciding if SMRT’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.