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 Comfortdelgro Corporation to the test
Let’s run transportation giant Comfortdelgro Corporation Ltd (SGX: C52) through this exercise today. In the chart below, you can see how the three components of Comfortdelgro’s ROE have fared over the past five years:
It’s fairly obvious that Comfortdelgro’s ROE (represented by the blue bars) has been a model of great consistency. Furthermore, the land transport services provider’s ROE has also been kept at an attractive level, having averaged close to 13% from 2010 to 2014.
The consistency extends to all three of the underlying components of Comfortdelgro’s ROE as well – they’ve barely budged.
The asset turnover (orange line) has clocked in at an average of 0.76 over the period under study, meaning to say Comfortdelgro has generated 76 cents in revenue on average for each asset dollar employed.
Meanwhile, Comfortdelgro’s financial leverage (green line) has hovered around the 2.4 mark – this indicates that the company uses a fair amount of leverage to fund its growth. This may not be what investors would like to see since high financial leverage may mean that a company’s playing a dicey game.
But the good thing is that Comfortdelgro’s financial leverage has been pretty consistent (it’s not trending up, which is good) and the firm’s cash levels has actually been rising in relation to its borrowings. The latter trait helps add a layer of financial robustness to the firm and you can observe the changes in the chart below.
Source: Comfortdelgro’s earnings report
Finally, and perhaps most importantly, Comfortdelgro has managed to maintain its return on sales (red line in first graph) as it grew its topline. Net margin was steady around 7% for most of the five fiscal years examined.
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.
The consistency of Comfortdelgro’s ROE and its underlying components is commendable, as is the level of the ROE itself. The challenge for Comfortdelgro is to continue to find opportunities to grow its revenue in order to maximize its ability to generate returns. If it can do so, we may have a winning company on our hands.
With that, the onus remains with the Foolish investor to decide if Comfortdelgro’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.