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…
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 dismantle 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’ 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 BreadTalk Group to the test
Let’s run popular local bakery chain owner BreadTalk Group Limited (SGX: 5DA) through this exercise today. In the chart below, you can see how the three components of BreadTalk’s ROE have changed over the past five years:
As you can see, BreadTalk’s ROE has been trending down for the timeframe under study. That said, the company has still been able to keep its ROE above a respectable level of 12%.
The main culprits behind the decline in BreadTalk’s ROE are the return on sales (red line) and asset turnover (orange line). The baker’s net margin fell from 3.7% in 2010 to 2.1% in 2014. Similarly, less revenue per asset dollar was also generated during this time frame with the asset turnover falling from 1.6 in 2010 to 1.2 in 2014.
Meanwhile, BreadTalk’s ROE was propped up by its increasing financial leverage for the period above. This may not be surprising when we observe how the borrowing levels at BreadTalk have increased sharply over the period stretching from 2010 to 2014. This is summarized in the chart below:
Source: BreadTalk Group’s earnings report
A Fool’s take
A winning stock may be found when it demonstrates a consistent track record of generating superior value for each shareholder dollar it has at its disposal.
BreadTalk has grown its top-line admirably over the past five years. Unfortunately, that has come at the expense of higher financial leverage and lower net margins. For the cautious investor, he or she may want to look for signs of profitable growth before committing any capital.
With that, the onus remains with the Foolish investor to decide if BreadTalk’s current share price provides an appropriate margin of safety and whether the company fits into his or her portfolio.
For more stock analyses and investing tips, sign up here for your FREE subscription to The Motley Fool's weekly investing newsletter, Take Stock Singapore. It will teach you how you can grow your wealth in the years ahead.
Like us on Facebook to follow our latest hot articles.
The Motley Fool's purpose is to help the world invest, better.
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.