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 Osim International to the test
Let’s run lifestyle company OSIM International Ltd (SGX: O23) through this exercise today. In the chart below, you can see how the three components of Osim’s ROE have changed over the past five years:
The first obvious thing to note is that Osim’s ROE (represented by the blue bars) has trended downwards over the firm’s past five fiscal years, moving from close to 50% in 2010 (Osim’s fiscal year coincides with the calendar year) to around 28.8% in 2015.
Of the three main components of the ROE, we may attribute its fall to the decrease in Osim’s asset turnover (orange line). Over the timeframe under study, Osim had generated an average of S$1.44 in revenue for each asset dollar employed. But in 2014, Osim had earned only 90 cents in revenue per asset dollar.
Picking up the slack is Osim’s return on sales (red line), which has moved up to nearly 15% in 2014 from around 10% in 2010. While less revenue per asset was earned, Osim has gotten better at squeezing out a profit per dollar of revenue made.
Finally, Osim’s financial leverage (green line) is marginally lower compared to where it was five years ago. That can be a good thing since higher financial leverage would also generally mean that a company has to face more financial risks.
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.
Although Osim’s ROE has fallen over the past five years, the company has still been able to keep its ROE at a very respectable level of 28% in 2014. The question here is whether Osim can maintain its good ROE and grow its revenue from here. If it can, it may help Osim to bring in bigger profits to its bottom-line and possibly enrich its shareholders in the process.
With that, the onus remains with the Foolish investor to decide if Osim’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 owns shares in OSIM International.