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 Singapore Post to the test
Let’s run mail and logistics company Singapore Post Limited (SGX: S08) through this exercise today. In the chart below, you can see how the three components of Singapore Post’s ROE have changed over its past five fiscal years:
What’s really obvious here is that Singapore Post’s ROE (blue bars) has fallen significantly over the period under study, moving from more than 50% in the financial year ended 31 March 2011 (FY2010/11) to 14.6% in FY2014/15.
There are two main drivers for the decline in Singapore Post’s ROE with one being the return on sales, which slipped from above 26% in FY2010/11 to around 17% in FY2014/15.
While Singapore Post’s net margin is still healthy, it’s worth pointing out that the operating profit from the firm’s all-important mail division has stalled over the past five fiscal years (see chart just below). This can be a potential point of concern for investors.
Source: Singapore Post’s earnings report
Elsewhere, the asset turnover ratio (orange line in the first chart) clocked in at an average of 0.51 over the timeframe under study, meaning to say Singapore Post had generated an average of 51 cents of revenue for each asset dollar employed.
On a brighter note, Singapore Post’s financial leverage (green line in the first chart) has declined over the firm’s past five fiscal years. While the fall in the metric had been a big contributor to the firm’s shrinking ROE, it also means that Singapore Post is now facing lesser financial risks.
As you can see in the next chart below, Singapore Post’s balance sheet has strengthened considerably over the years and this had contributed to the lower financial leverage.
Source: Singapore Post’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.
It’s not nice to see a ROE that shrinks, but it’s worth noting that Singapore Post has still been able to keep its ROE at a respectable level even in FY2014/15. The question here is whether Singapore Post is able to maintain its net margin and execute a transition towards a logistics- and eCommerce-driven business at the same time. This is a tough proposition, but the firm’s strong balance sheet may help support the transition.
With that, the onus remains with the Foolish investor to decide if Singapore Post’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.