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 Venture Corporation to the test
Let’s run electronics services provider Venture Corporation Ltd (SGX: V03) through this exercise today. In the chart below, you can see how the three components of Venture Corporation’s ROE have changed over the past five years:
At first glance, we can see that Venture Corporation’s ROE (represented by the blue bars) has trended downwards over its past five fiscal years, moving from above 10% in 2010 to around 7.6% in 2014.
Of the three main components of the ROE, we may attribute the fall in the important financial metric to the decrease in return on sales (red line). In this case, the net margin has declined from 7% in 2010 to around 5.7% in 2014.
Meanwhile, Venture Corporation’s financial leverage (green line) and asset turnover (orange line) have both been relatively stable over the time period shown above.
In the five years studied, Venture Corporation has managed to clock an average of about 98 cents of revenue for each asset dollar employed. The company’s average financial leverage has also been a decent 1.4.
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, Venture Corporation has struggled to keep its ROE at a decent level of at least 10% from 2010 to 2014. We will have to see if the company’s strategy to shift its business-mix to technology services and solutions will pay off over the long-term. At the moment, the benefits to the change in business-direction has yet to turn up from a ROE point of view for the company.
With everything we’ve seen above, the onus remains with the Foolish investor to decide if Venture Corporation’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.