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 SATS to the test
Let’s run catering giant and airport services provider SATS Ltd (SGX: S58) through this exercise today. In the chart below, you can see how the three components of SATS’s ROE have changed over the past five years:
First off, we can see that SATS’s ROE (represented by the blue bars) has trended upwards over its past five fiscal years, moving from above 12.8% in the financial year ended 31 March 2011 (FY11/10) to around 13.7% in FY14/15.
Of the three main components of the ROE, we may attribute its rise to the increase in the asset turnover (orange line). SATS has made an average of about 84 cents in revenue for each asset dollar employed over the period we’re looking at. With SATS ending FY14/15 with an asset turnover of 0.87, it appears that the company has gotten better in extracting additional revenue from its assets over the years.
Meanwhile, the return on sales (red line) has been relatively flat compared to where it was five years ago.
Finally, SATS’s financial leverage (green line) has decreased over the timeframe under study. This may not be surprising for those who have been tracking the catering giant’s balance sheet; the firm’s borrowings have steadily declined while its cash levels have grown. You can see this in the graph below.
Source: SAT’s earnings report
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 the case of SATS, it has been able to keep its ROE at a respectable level of around 12% over the timeframe we’re looking at and that’s something shareholders would be happy to see. But, the question here is whether SATS is able to grow its overall revenue from its current level. If the firm’s revenue grows, its ability to maintain a good ROE may help to bring in bigger profits – in this way, SATS is thus able to create value for shareholders.
With that, the onus remains with the Foolish investor to decide if SATS’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.